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While the mergers and consolidations of U.S. hotel companies and hotel real estate investment trusts (REITs) have been grabbing the headlines in recent months, there continues to be plenty of action in the hotel property market as money pours into the sector from lenders and investors alike. Nevertheless, this has been a tale of two markets, and the differences between them should be noted with care by anyone planning to invest in this industry. On the one hand, existing full-service properties are trading at escalating prices in urban centers and resort destinations where the barriers to new development entry remain high. That market continues to tighten. On the other hand, development in the limited-service sector gives all appearances of being a free-for-all in the suburbs, around airports and along highways where costs are relatively modest and financing is readily available. The limited-service market remains fed by a production-line development capability, the encouragement of franchisors with brands for every niche, format and concept, and a development opportunity that is always keen to build wherever it can.

Looking at the dynamics of this bifurcated market, one might conclude that investors in full service property have little to be concerned with, at least for the next several years. But will the best of times again become the worst of times? To find out, we explore the current trends in property pricing, the changing nature of buyers and where they are investing, underwriting standards and the type of capital flowing into the market.

A Seller's Market, If Ever There Was One

By all accounts, there continues to be excessive enthusiasm for well located, full-service hotel products - a seller's market, if ever there was one in the United States.  Hotel companies pursuing a merger and acquisition strategy to develop critical mass know that they need to track down individual property deals to stay in the race. Meanwhile, they face an array of hotel REITs with a voracious appetite for property financed with inexpensive capital. Two major REITs (Starwood Trust / Westin and Patriot American / Wyndham), have formidable business combinations with brands and an operating infrastructure. These REITs have a powerful competitive advantage in the hotel property market as savings in management and franchise fees, capitalized at high stock price multiples produce even more spending power than before.

Public companies facing slower earnings growth in their existing property portfolios must also acquire hotels to sustain the levels of growth required by their current price earnings multiples. Added to this brew are individual investors and property funds from the United States, as well as individuals and corporate investors from overseas, particularly Southeast Asia. In this milieu, slip-ups are probably inevitable. While buyers rationalize higher prices and lower returns for existing hotel property, they should be looking over their shoulders at a development community salivating at the prospect of loosening bank underwriting standards and increasingly available financing especially as acquisition and replacement costs in the full-service hotel market finally become aligned with each other.

To strategic buyers, including hotel groups with a need for market presence, new development does provide product that is purpose-built and engineered at least with the intent of maximum efficiency. This is in contrast to the compromises frequently present in older property that requires "fixing up." With a development lead time of broadly two to three years for the full-service segment, however, it will be several years before full-service development activity shows up in bricks and mortar, and along with that the threat of supply exceeding demand. Today's full-service buyers, however, should be aware that the current static supply paradigm won't last forever. For those focused on luxury property, capitalization (cap) rates have continued to drop during the past year, although the pace of decline appears to have slowed as acquisition pricing gets closer to replacement cost. Despite this, there will always be an elite group of buyers who will pay a premium for the franchise or strategic value of a trophy asset in a key market.

For institutional players, the returns from hotel property tend to be benchrnarked against other product types. Always a bellwether in the world of commercial real estate, cap rates have seen some significant declines of late in the office sector. Major office buildings trading at cap rates of 6 and 7 percent, while highlighting the comparatively attractive returns in the hotel sector, also put additional downward pressure on hotel cap rates. During the last year, cap rates on well located full-service property have probably declined by as much as 100 basis points.

Small funds and entrepreneurial types continue to try to put together pools of property to be re-flagged, repositioned, reconfigured, seasoned and then sold. But this kind of activity is much diminished from where it was just a few years ago. The economic drivers have also changed. Today's such investors rely not only on the appreciation of the real estate but also on the ability to exit in some sort of public vehicle, while prices remain high. For traditionalists who thought they understood the basic fundamentals of property valuation - stabilized cash flow capitalized at risk-adjusted cap rates, the market may be too hot to handle right now. They should not despair, however. Relief could come earlier in the guise of rising interest rates and a downturn in the stock market, or later as new development finally takes hold. And with the Federal Reserve ever anxious to dampen the underlying inflationary pressures that must now be building - the former probably will come well before the latter.

For those people who don't have a strategic reason to hold onto hotel property, it is probably a good time to sell. This is especially the case for those opportunity players who entered the market in the early 1990s and now see their yield curves flattening. These investors can still achieve solid returns as they depart. A "sell" strategy today is also relevant for the institutions (both domestic and foreign) that have been slow to clean up their balance sheets after gorging on real estate in the late 1980s, either because they couldn't afford to or because they were preoccupied with other graver problems. And while some might argue that selling at this point in the cycle might leave money on the table, it may be hard for some institutions to ignore the current enthusiastic frothiness on the "buy" side.

Access and Cost of Capital

Property prices are also affected by the availability and cost of acquisition capital. With inexpensive equity from the public markets and tightening spreads in the low cost and now much more available debt market, an abundance of capital has continued to drive down "going-in" cap rates. Cheap capital sourced by public companies is, for the most part, out-bidding the traditional players - wealthy individuals, institutions, opportunity funds and the like. Foreign buyers who continue to be willing to pay a premium for the comparative stability and consistency of the U.S. economy remain in the game, while the "hot money" (contrarian investors, vulture funds and bottom fishers) have long since departed.

Also a key factor driving the market are underwriting standards. Are they weakening just as new development returns to the full-service hotel property segment? While few would care to admit it, the scene of all-cash
buyers making snap decisions using commodity pricing on property they have barely looked at - much less taken the time to understand paints a troublesome picture. As the distinction between real estate commodity and complex operational and marketing business blurs, we should be careful lest we lose sight of what drives value in hotel property - it's clearly the customers. One anecdote heard in the halls of hotel banking quite recently had the banker calling the appraiser to raise the value because they really wanted to make the loan. Hello?

For lenders using securitization as an exit into the public market, the standards in theory remain rigorous with rating agencies riding herd on loose underwriting. Public companies remain conservatively leveraged from a balance sheet perspective. As property prices and the debt to pay for them continue to rise in a period when cash flows begin to stabilize, however, debt service coverage ratios will inevitably narrow, producing higher levels of risk. How main-line lenders will react to this reality is yet to be seen. Meanwhile Wall Street is not missing a beat, providing all of the requisite funds, but splitting the risk using a variety of "mezzanine" financing products that act like "quasi-equity." On the private side, however, some lenders are again looking at 110 to 90 percent leverage, providing little room for error.

Foreign Investors - Crowded from Market

Foreign investors, who in the early 1990s made approximately one-half of the major hotel property purchases in the United States, are now being crowded out by domestic players. Some may also be realizing that there are attractive acquisition opportunities closer to home where the real estate crunch looks like a repeat performance of the earlier U.S. experience. Witness Thailand, Indonesia, Malaysia, France and Germany.

This notwithstanding, we will continue to see very active plays being made by key foreign investors determined to establish a presence in the U.S. hotel market, especially in cities that can easily be recognized on a map from a distance. And while our spotlight may currently be on the United States, some of these innovators are becoming quite global in their appetite - happy to swing from North America to Europe, and from there to Asia. Meanwhile, U.S. -based investors are also beginning to stretch their wings a little, although they tend to travel less far, concentrating in the neighboring Canadian and Mexican markets. Europe is on many agendas, but there appears to be more talk than action for now.

Another trend of note is the more recent willingness of some buyers to now take on property encumbered with existing management contracts. Whereas in the earlier years of the most recent upturn, buyers insisted on controlling management and taking property only under conditions of "vacant possession", they are today beginning to realize that the price premiums for this may not be worth it. This is reflected in the cap rate premiums associated with such vacant possession - and while they undoubtedly vary depending upon the circumstances, they have clearly declined from some 300-400 basis points in the depths of the property recession to on the order of 100 or so basis points today. This may be welcome news for management companies, but they should nevertheless expect some re-working of their contracts especially if they date from the 1980s and are weighted too much in their favor.

The U.S. hotel property market continues to offer plenty of opportunity, but there is an acute need to be selective, more so today than at any time in this latest long upturn. The turnaround in hotel Industry profits since 1991 has been extraordinary, and it is thus hardly surprising that the industry and its real estate underpinnings have come in for a great deal of attention. But for those who continue to invest in physical assets at this stage in the cycle, distinguishing between the good, the bad and the ugly in a bifurcated market is a "far, far better thing" to be doing than expecting the great times to last forever..