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By Jeffrey C. Summers -  Chicago

The investment market in the U.S. hospitality industry set a swift pace in the first quarter of this year amid forecasts that 1996 may be the most profitable year ever for the hotel sector. The economics of the industry have become a compelling magnet for a broad profile of investors as large amounts of equity capital continue to chase a diminishing number of deals.

To assess the current investment environment, Arthur Andersen updated its investor study from last spring by conducting a new survey of select hotel investors in the domestic and offshore arenas. Major investment entities surveyed for the 1996 study, conducted earlier this year, included 20 organizations representing varying constituencies in the investment community. Among them were investment groups and hotel owners, hotel companies, developers, brokers, institutional investors and investment banking firms. Together, the two studies provide comparative information on a hotel investment market that can only be described as vibrant. Indeed, this year's survey corroborates emerging trends evident in the 1995 study.

In this seller's market, many of the organizations surveyed said their net new investment in hotel property in 1996 would exceed last year as the focus remains on acquisitions of full-service hotels, which continue to trade at below replacement cost. The smart dollars appear to be flowing almost exclusively into hotels in the mid-scale and upscale segments where it remains considerably less costly to acquire than to build. Not surprisingly, the investors surveyed cast a cautious eye at the limited service sector where acquisition costs are virtually on a par with new development, a scenario that has contributed to expanding supply. Limited service properties and markets where there are no barriers to entry were cited by these investors as areas to be generally avoided or at least approached with a healthy level of trepidation.

Interest in U.S. hotel property clearly has not peaked, with the hotel industry viewed as one of the strongest - if not the strongest - real estate sectors domestically. There is debate among real estate professionals whether hotel or industrial property represents the best real estate play in 1996. Either way, hotels rank ahead of retail, office and residential on almost everyone's list of sound investment vehicles. Yet with hotel prices up and capitalization rates down, it is dear that the best acquisition "bargains" have long since left the market - to be replaced by sound deals offering lower potential yields but with lower risk, at pricing that reflects where the industry stands today in this up cycle. In spite of the maturing transaction environment in the United States, there remains an apparent disinclination to risk sending capital overseas to markets that might otherwise represent greater opportunity. Only one-quarter of the investors surveyed said they would entertain b' vestments outside the United States. While the growth in demand continues to outstrip the growth in new supply, the pace of demand growth has slowed over the past year. This is offset somewhat by a continued rise in room rates significantly in excess of inflation, which has produced substantial increases in overall revenue and thus profitability. It is this strength of the domestic market that remains the alluring aspect of opportunity in the hotel sector.

Overall, the survey findings draw a profile of an exceptionally active investment market with funds available for hotel acquisitions growing in magnitude as investors capitalize on fundamentally solid hotel market conditions and the health of the U.S. economy. With virtually no new development of hotel product in the full-service segment during the last six years, existing owners/operators and investors are enjoying the benefits of a market in which the growth in demand continues to exceed the growth in supply by a substantial margin.

Buyers and Sellers

The majority of investors surveyed purchased hotel properties in 1995 and plan to do so again this year. The sellers of such hotel properties, however, varied significantly. Arthur Andersen's 1995 hotel investor survey revealed that the bulk of the properties on the market were being sold by commercial banks and insurance companies, but the study forecast that property sales by private entities would emerge in greater numbers as the recovery proceeded. Survey findings this year substantiated that forecast. Rising prices clearly have been a motivation for certain private owners to put their properties on the market. Yet it is also clear that some private owners are riding a wave with the top of the cycle potentially some years out; appreciation in hotel property prices is likely to continue with sustained economic health and the industry's profitability. Many U.S. banks have sold their troubled hotel assets, and these institutions are being replaced by Japanese banks as reluctant owners and sellers-by-necessity, many of which are expected to emerge as a dominant source of property sales in the near future.

Pricing for acquisitions continues to inch up, according to investors, with mark-downs now a thing of the past. Investors also report that the demand for higher-quality properties with stable cash flows or upside potential is
exceeding the supply for these types of properties. While it has become increasingly difficult to buy first-class, full-service hotels, marginal products in terms of quality and age are beginning to hit the market.

The Strategic Rationale

Given this prognosis, investors have adopted diverse strategies within a basic framework of targeting full-service hotels, generally to the exclusion of limited-service properties. Approximately two-thirds of investors surveyed reported an emphasis on acquisitions with the potential for upgrading and repositioning in the market, as well as creating value through brand conversion. In addition, targets included hotels in markets with significant barriers to entry. This is much in line with last year's survey, which revealed hotel companies and investment groups aggressively seeking full-service properties at prices below replacement costs. The intent was to capture strong upside potential   either from capital refurbishing or installing management capable of cutting costs and generating a stronger profit picture. For short-term owners, those recently surveyed reported strategies revolving around purchasing turn-around properties with the aim of improving net income. From a valuation standpoint, investors today are willing to pay a higher premium for properties with upside potential and report using capitalization rates below 10 percent.
 
 

Encumbrance by a management contract was cited as the greatest single impediment to an acquisition, a finding that is consistent with last year's survey. Investors are typically seeking properties which are 'free and clear' of existing management to ease repositioning or conversion to a new brand. Investment groups seeking upside potential need as much flexibility as possible in replacing management teams, while hotel chains also will want to install their own management in a newly acquired property. Hotel properties encumbered with existing management contracts additionally pose more difficulties for resale. Other major hindrances to a transaction include environmental problems and ground leases. As noted in last year's survey findings, investors generally require that a land lease have at least 40 years remaining to ensure that it will not have a negative impact on the property's potential for future resale.

Clearly, the bulk of activity in the full-service sector revolves around acquisitions because costs of replacement for existing properties remains substantially higher than purchase costs. As investors continue to drive up acquisition prices, however, development opportunities for the most courageous will begin to appear. Some industry leaders believe construction for even full-service properties may resume this year in major cities and airport locations in urban areas. Occupancy levels for hotels in Manhattan, for example, were above 90 percent for the entire month of October and averaged nearly 80 percent for the full-year 1995. Such markets will provide a fertile ground ultimately for new development on the full-service side. The general consensus, however, was that new full service hotels won't begin rising out of the ground in significant numbers until 1998 or 1999. In light of the difficulty in obtaining financing for such projects, even this may be a somewhat optimistic view.

Some of the new construction of lower-end hotel products appears to be healthy for the industry, particularly as it arises from owner/operators with extensive local knowledge developing properties that they will retain as an on-going concern. Development of select properties, for example, is taking place in local areas undergoing high growth as a result of new commercial or retail development. The economics of the hotel project, as a result, are linked to new demand being created in a specific local market. This is in contrast to projects driven by larger investors, such as insurance companies, where local knowledge may be limited and projects are undertaken for a variety of motivations.

All Cash vs. Leveraged Deals

As the hotel sector has moved firmly into full recovery, debt financing available for acquisitions also has surfaced once again in the marketplace. Last year, the Arthur Andersen survey revealed that the majority of deals were being completed on an all cash basis due to the liquid position of investors and the lack of financing available. This year's findings stand in sharp contrast. Investors surveyed unanimously agreed that debt capital is easier to secure. A significant number of deals remains in the all-cash category, but it is evenly balanced by leveraged transactions. Yet the large commercial banks remain extremely cautious - apparently wishing to keep the industry at arm's length for now, according to respondents. The smaller community and local area banks were much more likely to provide debt capital to hotel investors. At the top of the list of financing sources are credit companies (such as Nomura and Credit Lyonnais), followed by insurance companies, banks, conduits, private funds and Wall Street.
 
 

Investors surveyed reported debt capital available at a range of interest rates - varying on average from 200 to 300 basis points above various benchmarks such as Treasuries or LIBOR. Last year's Arthur Andersen survey of investors reported interest rates between 275 and 400 basis points above the same benchmarks, suggesting that rates have fallen. Required debt service coverage ratios were reported to be primarily between 1.3 and 1.5, while certain investors indicated lenders were seeking DSC ratios of in excess of 1.5. The majority of investors indicated amortization periods continued to fall in the 20 to 25 year range.

The actual cost of debt capital, as a result, appears to be less expensive than a year ago for a variety of reasons. The Federal Reserve has further reduced interest rates, and the hotel industry's strong fundamentals continue to reassure lenders. Also apparent is that Wall Street's involvement in debt securitizations and hotel REIT issues has not only been a source of new capital for the industry, but also lent credibility to hotel finance in the capital markets generally. Securitizations have required issuers of hotel debt to meet rating agency requirements for tranches of debt, similar to regular corporate bonds, while a new level of sophistication has come to the industry with the success of large-scale capitalizations in the hotel REIT market. While Wall Street has of late brought a higher level of expertise and discipline to hotel finance, it remains to be seen whether the traditionally jittery nature of the public markets will stay the course during the next downturn, whenever it comes.

Investment Parameters

The Arthur Andersen survey of hotel investors reveals that investment criteria currently reflects the intent to look to the future. There is continuing evidence that acquisitions are no longer based on historical earnings, but rather are focused on current and future earnings. Investors report they are currently valuing hotel real estate based on internal rates of return (IRR), discounted cash flow (DCF) analyses and cash-on-cash return. Two to three years ago, it was more common for investors to use methods of valuation involving direct capitalization of the prior years' income, a method which looks back to historical earnings.

When a DCF method is used, investors this year reported that prospective cash flow is generally projected out five years. This is in contrast to last year's survey when investors reported a horizon between seven and 10 years used in DCF analyses. The difference may be due to a reluctance on the part of investors to forecast when the current cycle of the hotel industry will peak, as well as other uncertainties relating to longer-term health of the U.S. economy. Investors reported IRR requirements of an average 19 percent. Cash-n-cash requirements fell primarily in the 13 to 14 percent range, slightly lower than what was reported in the 1995 survey. At the same time, targets for unleveraged return on equity averaged 15.5 percent, while the average for leveraged returns was at 22.5 percent.

When investors are using a direct capitalization valuation method which at this point is primarily used as a reasonableness check - the overwhelming majority reported capitalizing the last calendar year's or the trailing 12 months' NOI. This group of investors surveyed reported cap rates in the range of 10 to 11 percent. However, it is clear not only from our recent research but from a number of recently completed transactions in the market place that investors have bought property using lower cap rates, typically ranging from 9 to 10 percent, under certain circumstances. This range is most prevalent for properties in short supply, recently constructed full-service properties and hotels in strategic locations.

Management fees generally were being calculated at 3 percent and replacement reserves at 3 to 5 percent. Reserve percentages for furniture, fixtures and equipment (FF&E) cited this year were similar to survey findings last year when investors reported percentages at 4 to 5 percent.

Investors who considered replacement costs as a factor in hotel acquisitions indicated that they were targeting full-service properties priced from 60 to 80 percent of replacement costs - but with the average falling at approximately 65 percent. In the limited-service segment, few properties are selling below replacement costs and propitious market conditions have prompted a wave of new construction in this segment.

Forecasting the Market Cycle

Overall, investors surveyed this year expressed strong optimism for the full-service hotel sector today and for some time in the future. On the limited-service side, there is some concern that select markets may become overbuilt.

Yet smaller investors - particularly local owner/operators - generally have a hand on the pulse of local markets, and so far construction is accommodating the need to eliminate product obsolescence, as well as match new demand. What is critical is to determine accurately when that demand is met and a cycle of oversupply begins. The potential for overbuilding, however, will be greatly tempered by the amount of debt capital available as traditional lenders remain cautious, with requirements including significant amounts of equity. In short, there is simply too little capital - even with the investment activity - to drive significant overbuilding in the upper end of the hospitality industry currently.

Opinions differ as to when the cycle will reach the top and acquisition prices will level oft. Generally, the consensus was that the industry is two to three years away from reaching a peak, unless an economic recession derails steadily improving fundamentals. Hotel room demand tracks percent changes in gross domestic product (GDP) with a good deal of precision; therefore, as long as the economy continues to expand, so too should the demand for hotel rooms by the traveling public. Nevertheless, demand growth appears to be slowing significantly while prices for hotels continues to rise - which should be viewed as cautionary signs.

Despite the enthusiasm, it is also clear that as prices for properties climb, the high yields realized by investors who targeted acquisitions earlier in this decade are a thing of the past - at least until the next cycle. The "smartest" money acquired hotels in the trough which occurred four to five years ago, and has undoubtedly moved on following that speculative wave of acquisitions. Opportunistic and contrarian investors who look for acquisitions in "buyer" markets may do well to seek such opportunities overseas in countries which have political and economic stability - and markets that are close to "bottoming out." While there does not appear to be a great deal of interest among U.S. investors in overseas markets, it is here that the opportunities characteristic of the domestic hotel market in 1991 may be surfacing in today's global economy.

Nevertheless, there are solid investments still to be made in the United States, as demonstrated by this investor survey. Of the organizations reporting they will make hotel investments this year, nearly two-thirds plan to invest more - not less - money in acquisitions. The focus continues to be capturing upside value as industry economics push industry profits to unprecedented levels.

Jeffrey C. Summers is Director of Hospitality Consulting for the Chicago office of Arthur Andersen.

©Arthur Andersen

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