By Roger S. Cline - New York
As the relationships between operating and real estate interests in the international hotel industry continue to consolidate, the labor and capital intensities of the industry have come into sharp focus. While there is plenty to be concerned about regarding the labor side of the equation productivity, education, training, job fulfillment and the impact of technology come to mind - there remains a major challenge on the capital side. In a world where there is a general shortage of capital, hospitality companies must now work much harder in the global competition for money. And as the industry begins to recover in many countries from the excesses of the 198Os, the search is on for new solutions to the capital dilemma.
Accentuating the dilemma is the fad that the losses of the early 199Os and the associated declines in property values have scared away many of the industry's traditional private capital providers. And they do not appear to be returning anytime soon. So it is not surprising that in some markets around the world there is strong interest in public financial markets as a place to seek capital, even though they tend to present some very unique challenges.
This article is thus dedicated to a review of public market financing of the hospitality industry. Securitization of hotel property and corporate financing has been a popular item in capital markets in the United States during the last several years and looks set to become a permanent feature on the financing landscape. Elsewhere around the world, the use of public markets to fund the international hotel industry is spotty at best. But before visiting some of the new public market frontiers of hospitality industry finance, let us first look at what is going on ix' the United States.
For many years, the U.S. hotel industry benefited from the largesse of private institutional capital, primarily the insurance industry, savings institutions and commercial banks to fund property expansion and acquisition. With these resources no longer as available, the industry has been forced to turn to alternative sources such as the public market and has had to adjust to a new set of rules.
REITs...A Hot Topic
As 1994 came to a close, Securitization of hotel property and mortgages in the United States was a very hot topic. Real Estate Investment Trusts or REITs (which distribute earnings from real estate, free of corporate taxes) had become high fliers in the stock market. Having finally dealt with the structuring challenges that are unique to REITs and previously made hotel REIT formations problematic, a series of issues came to market in late 1993. These tended to be relatively small issues but they delivered some of the best stock performance in the REIT sector, with investor interest driven largely by the turnaround in the U.S. hotel industry that continues to this day. Following these initial successes, secondary offerings came to market during 1994 and the general enthusiasm was palpable. But with interest rate escalations throughout the year, the fervor began to fade and by late 1994, the market had retreated. Uncertainty concerning the outlook for hotel REITs was widespread with the conventional wisdom being that it would be a while before we would see any resurgence of interest.
Well, what a difference a year can make. This past year finally turned out to be a significant one for public market financing of the U.S. hotel industry. There was a renewed interest in REITs late in 1995 signaled by the successful launch of the largest hotel REIT yet - the $305 million Patriot American issue involving a portfolio of 20 hotels. And earlier in the year, Starwood Capital successfully recapitalized Hotel Investors Trust, a "grandfathered" REIT that had been operating for years with a unique paired share structure that allows the REIT to manage as well as own property - something other REITs are not allowed to do. As these large hotel REITs have come to market, there appears to be an appreciation for size that translates into more favorable pricing. This suggests that small capitalization REITs may not see as much popularity as heretofore when they essentially had the market to themselves.
REITs both large and small are but examples, however, in a large public financial marketplace that is increasingly serving the capital needs of the U.S. hotel industry. During the last four years, approximately $4 billion of capital has been raised for publicly traded hotel companies and $1 billion for hotel REITs - split evenly between debt and equity. And the pace quickened in 1995 with a steadily rising stock market. Hotel industry financings were up by one-third over the prior year at approximately $2 billion.
Following the fall-off in the REIT market late in 1994, the market for new hotel REITs had been slow in returning. But with the success of the large Patriot American deal, the market seems ready for more. Interest rates, however, have a big impact on the REIT market, so future activity will be sensitive to interest rate volatility. on the basis of a stable interest environment, however, it is estimated that hotel REITs might represent as much as ~ billion in 19%. Easier to predict than volume is the style or structure of future hotel REIT financings. They are likely to be large and well-covered by Wall Street's research analysts - an essential element if an issue is to gain any respectability and following.
Hotel REITs have also tended to be all equity offerings with lines of credit to fund expansion - but these lines can run out quickly following an active property acquisition program. Future hotel REITs will therefore need to develop capital structures that present blends of debt and equity in an effort to reduce the weighted cost of capital and provide for better balance as the capital base is expanded.
Since quality sponsorship is so critical to success in public markets, it also appears likely that we will see fewer Initial Public Offerings (especially during a period of consolidation) and more secondary offerings involving the return to market of well-established hotel companies with a proven track record. No matter how much enthusiasm exists for the industry's positive economic situation, there is little doubt the focus in the future will be on management and its ability to deliver through the next cycle.
Resurgence of "C" Corporations
In addition to the return of hotel REITs last year, there was also a resurgence of activity involving "C" Corporations - traditionally structured companies that have historically been the main players in the public market, A series of new C-corp issues attracted a great deal of institutional investor interest, something that is not always as prevalent on the REIT side of the market. Some small C- corp issues also showed very strong growth stories as the hotel market has turned around. This has attracted a lot of new investors, which is clearly healthy in broadening the base of investor support for the industry.
An interesting trend is the growing acceptance of hotel real estate as part of a public company's balance sheet. Notwithstanding the tendency for the stock market to focus on short-term earnings, some of the recent hotel C corp issues have suggested that hotel property ownership can be appreciated, particularly if it delivers operating leverage in a period of rising occupancy. Of course this appreciation can disappear quickly in a downturn when the leverage works in reverse and delivers losses very quickly.
The public market tends to value a growth story. Working against this concept in the REIT arena is the requirement of the tax code that 95 percent of a REIT's earnings be distributed out to the investors each year. As a consequence, for those companies trying to build franchise value through customer relationships and in need of a constant source of reinvestment capital, the REIT structure is not generally a suitable vehicle. But for those with large real estate portfolios, judicious use of the REIT format for "off balance sheet" property financing can produce a satisfactory outcome. The lease format used by hotel REITs to address the tax laws' prohibition of involvement in the management of the property, tends to secure a long-term involvement with the property - something that is of particular value in a market where traditional property owner/manager relationships have become far more tenuous and unpredictable.
In the context of the hospitality industry at large, it is worth mentioning the gaming industry's involvement with public market financing. Gaming companies have long been involved with the public markets as a result of not being able to tap into private institutional sources of money. Without the respectability that it has today, gaming companies originally had to operate in the high-yield market. And as the gaming sector grew and the earnings escalated with new jurisdictions, a compelling story for gaming stocks has developed in recent years.
More recently we have seen the setbacks of poor press, some negative votes against new jurisdictions and one or two high-profile bankruptcies. This can quickly dampen the enthusiasm, and so it remains to be seen as to what the longer-term public market environment will be like for gaming companies. For those with experienced management, a well established franchise and customer following, and a position in established jurisdictions, there should be few difficulties. For those at the margin, however, it will be another story. And indeed we can expect to see a consolidation and shakeout as the gaming industry refocuses its attention on the strong players who are well-positioned to benefit from the trends in a variety of gaming jurisdictions across the country.
In evaluating whether to take a hospitality company to the public market for the first time, it is worth reviewing some simple fundamentals to determine if a company has what it takes to make it through the rigorous initial public offering process. Look for the following: the nature and energy level of the management team, stability of earnings, a solid outlook for growth and a focused story and business concept. Other issues to be contended with include the extent of existing leverage, the current owner's objectives and pricing expectations and the need for debt versus equity and their relative costs.
Otherwise successful companies also must recognize that taking a company public for the first time will probably mean facing a discount in value to account for the unknown. The countervailing view is that public market investors driven by the hype surrounding a bull market may value a high-profile hospitality company significantly in excess of what the private market might judge the stock to be worth - the herd mentality one might say. Timing is, of course, everything.
As Wall Street becomes more involved in hotel property financing, it is not surprising that the rating agencies (Standard & Poor, Duff & Phelps, Fitch and Moody's) have begun to play a role. Ratings have tended to be associated with the packaging of small hotel mortgages into Real Estate Mortgage Investment Conduits or "REMICs." Such conduits tranche the capital into various risk levels that carry a range of ratings and are priced accordingly.
REMICs were expected to play a big role in hotel financing especially as these programs were supported by some of the country's largest franchisors as a service to their franchisees. But they turned out to be relatively expensive for borrowers of small amounts. As the industry turned around, there was more competition from local banks willing to finally take a closer look at their neighborhood borrowers who had been ignored since the real estate collapse in 1991.
As the rating agencies look at hotel debt issues, the factors of importance include portfolio diversification (both geographic and by property type), the adequacy of management fees, the presence of satisfactory replacement reserves and the structure. Whether rating agencies can play a role in encouraging an expanded role for public market financing of the hotel sector remains to be seen. The early signs are that they are interested in understanding the business and appear willing to participate.
And yet even if there is a willingness on the part of the rating agency community to play a role, it must be recognized that at its heart, the public market is far more fickle than the private market. Sentiments of sup port and enthusiasm for an industry can evaporate quickly if there are unexpected setbacks. Conventional wisdom at the moment, however, seems to suggest that the U.S. hotel industry's fundamentals are positive and the upward trend in profitability should continue for at least two more years. Demand for hotel rooms, however, tracks extremely closely with the underlying change in Gross Domestic Product. So as goes the economy, thus will follow the hotel industry. And if the economy falters, expect to see some major interruption in the otherwise rosy outlook for hotel stocks and debt issues.
But even if the industry continues on its present positive track, we should not assume that the public markets will provide all of the answers to the liquidity crisis for the industry. Considering the overall size of hotel financing needs in the United States, which we estimate at $8 billion annually, the public markets account for only a modest portion of the need at approximately 15 percent.
Because of the hotel industry's fragmented structure, its real estate orientation and its general reputation as part real estate/part business, we have not seen as many publicly quoted hotel companies as one might expect in an industry of its size. This hopefully will change in future years as the hospitality industry gains further respectability and hotel corporations enlarged through the process of consolidation seek broader access to public capital.
Consolidation can also have a counterpoint, however, and in the U.S. hotel and gaming industries this means de-consolidation. Two companies are of particular note in having split or attempted to split their gaming and hotel operations - Promus and Hilton. Marriott Corporation split for different reasons in an attempt to separate their real estate from their operational activities. And finally Sheraton Hotels, a stalwart of the U.S. hospitality scene, is now part of a split-up by parent ITT of its varied businesses into three groupings. The first, ITT Destinations, is the consolidation of its hospitality, gaming, sports and entertainment businesses. The public market reactions to these reconstitutions of hospitality companies have by-and-large been favorable, suggesting that it pays to continuously look "outside the organizational box" when trying to create shareholder value.
As hotel groups become larger and operate on a truly global basis, we are likely to see simultaneous hotel company listings in key financial markets around the world such as New York, London and Tokyo. one of the advantages of such international public market exposure relates to the quest that many hospitality companies have for global brand presence. Customer focus deriving from a brand strategy can quite reasonably tie into shareholder relationships on a global scale. It is just a matter of time.
World Finance Markets
And so to other financial markets around the world....
Chris Evans, director of corporate finance-hospitality and leisure in the firm's London office, reports that London's public market has not historically been of major significance in the financing of development, or of mergers and acquisition activity in the hospitality and leisure sectors in the United Kingdom.
In the past, many lenders and institutional and individual investors have viewed the hospitality industry somewhat suspiciously, and have preferred to provide corporate debt to hotel companies or to purchase shares in quoted hotel companies to spread sector risk as widely as possible. This preference has meant that the industry has been characterized by relatively unsophisticated financings.
The ownership structure of the industry in the United Kingdom has also been of influence in this regard. Hotels tend to be owner-operated and, with relatively few exceptions, the major hotel owning and operating companies are subsidiaries of conglomerates (for example Holiday Inn which is owned by the brewing company Bass PLC; and Hilton International which is only one of Ladbroke PLC's business units). Where capital has been required for development and M&A activity at such companies, it has normally been provided by the parent company since, generally speaking, corporate debt at such a level is rather less expensive than project or deal-specific debt.
Furthermore, in the United Kingdom there are relatively few independent hotel management companies operating hotels under franchises from the major international brands. In the United States such independent companies have been great users of public market capital. Those which do exist in the United Kingdom are small - in most instances operating two or three hotels. Development and acquisitions activity at such companies tend to be financed on a project-by-project basis with security provided by the asset to be financed plus, in many cases, additional company or personal guarantees. The one major exception to this general rule is the Whitbread Hotel Group (formerly Scott's Hotels), which owns and operates 13 hotels under franchise agreements with Marriott International. Whitbread Hotels Group, however, is a relatively small subsidiary of Whitbread PLC the brewing company, and funds for the £185 million acquisition of the 13 Scott's hotels were provided by the parent company.
Special share issues (such as rights issues and convertible preference share issues), however, have been used among the relatively few quoted "pure" hotel companies - particularly during the late 198Os. Oueen's Moat Houses financed a series of corporate and individual hotel property acquisitions via rights issues.
Turning to the future in the United Kingdom, given the capital intensive nature of the industry, we have observed an increasing interest among both the major conglomerates and the (few) independent hotel owned management companies in innovative financing methods - particularly in off-balance sheet financing. We believe that this interest will extend in the future to public capital markets. As recovery in the sector in the U.K. continues apace, we foresee a much wider interest among both providers and users of such capital.
From Tokyo, Arthur Andersen partner Kenji Ushitora reports that with the Japanese economy struggling for a soft landing and with banks still trying to deal with the challenges posed by their sizable exposure to real estate, the hospitality industry does not maintain any particular visibility in the public markets. The hospitality sector has been traditionally housed in large corporations with financing obscured from public view.
And in Germany, the hospitality industry's experience with the public markets is in its developmental stages, reports Hospitality Consulting Director John Litzenberger of Arthur Andersen's Frankfurt office. Kempinski is the only publicly quoted company with just six hotels in Germany and a total portfolio of only 30 properties. With an overbuilt domestic market, there is little demand for new capital, public or otherwise to fund new activities. The large German chains are by-and-large privately owned -- Maritim, Steigenberger and Arabella -- and do not come to the public market for capital. Closed-end property funds that do trade publicly will have some exposure to hotel real estate but it tends to be mixed into a large diversified portfolio. In summary, the German hospitality sector clearly is a long way from using public market financing in the way that companies do in the United States. This might change in the future, suggests Litzenberger, but it will be a long rime in the making.
In Australia, Phil Kasselis, Director of Hospitality Consulting in the firm's Sydney office, reports that the Australian Stock Exchange has 16 listed companies in a Tourism and Leisure Index. The TL Index was established in 1994 with over half the index made up of casino stocks. The index outperformed the market by a factor of 3:1 in 1995, confirming the enthusiasm investors have for the fast developing gaming industry and the fundamentals of the hotel sector, where demand growth continues to outstrip supply and should continue to do so for the next several years and probably up to the year 2000 when Sydney hosts the Olympics.
In the Australian property funds, where hotels as an asset class are generally under-represented, we should see an increase in the allocation of capital to this sector as profits return and the hotel industry outlook remains positive. Casino operators, hotel owners and hotel management companies will also expand their presence in the public financial markets, finding it a cheaper and easier way to raise capital than traditional bank debt. Large institutions are also likely to increase their involvement with publicly listed hospitality companies.
In summary, the international hotel industry has a long way to go in truly capitalizing on the opportunities afforded by public financial markets. The securitization of real estate has developed rapidly in recent years in the United States, but may be much longer in coming to other markets elsewhere, where traditional methods of financing are slow to change. Financial adversity will, however, force users of capital to source their needs in the public domain. It will require some big adjustments in approach and some serious corporate soul searching to get there. But it can be worth it and in a world of capital shortage, hospitality companies may have no choice but to force their way in. And as they say in the travel business... getting there is half the fun.
(Roger S. Cline is Worldwide Director of Arthur Andersen's Hospitality Consulting Services. He is based in New York.)