Luxury hotels and destination resorts are now prized by institutional investors and the hospitality industry.

By. James R. Butler, Jr. and P. Peter Benudiz

Few experts in the hospitality industry would have predicted it two years ago, but the market for hotels in general, and the luxury segment in particular, has heated up to near 1980s levels. This is not to say that values have come back to those of the 1980s but rather the investor community has focused on the hotel industry as being one of the significant investment opportunities in the 1990s.

Many reason have been offered by various experts in the industry as to why hotels have garnered such attention from the old-line and nouveau capital sources, but chief among the reasons is the fact that there has been virtually no new product introduced into the market since the early 1990s, while demand has been steadily increasing since 1991. According to Paine Webber, Inc., average occupancy rates for the luxury segment has increased form its low point of 66.3% in 1991, to the 1994 average occupancy rate of 71.4% .

According to Paine Webber’s economic analysis and market forecast, 1995 should prove to be a banner year for luxury hotels, with average occupancies exceeding 74 % for the year. The steady increase in average occupancy since 1991 has also been complemented by a strong increase in the average daily rate achieved by luxury hotels since 1991. This pattern of increased occupancy and a strong positive trend in the average daily rate in the luxury segment has resulted in a rebound in the value of luxury hotels. In 1991, the luxury hotel segment recorded its most meager increase in the last seven years with a .07% increase in the average daily rate for that year. Since then, however, the average daily rate for luxury hotels has crept upward in virtual concert with the overall rate of inflation . This trend is expected to continue in 1995 with experts predicting that luxury hotels will see a 4.5% increase in average daily rates for 1995 .

Decline in Room Starts

While the positive trend for luxury hotels in rates and occupancy may seem surprising at first blush given the avalanche of negative publicity that the hotel industry (especially luxury hotels and destination resorts) has received over the last five years, those trends can easily be explained by the dearth of new room starts in the industry. Room starts have declined almost 80% in the hotel industry since their high in 1985. The lack of new construction during the last five years has allowed the hotel industry to begin to recuperate from its 1980s development and construction binge.

With no significant new product coming on-line, and the general economy beginning its turnaround, the hotel industry has begun to feel the positive effects of an equilibrium between supply and demand. This tenet of basic macroeconomics theory has contributed to the increase in the rate and average occupancy that hotels have been achieving during the last several years. This, in turn, has translated into higher valuations for hotels across the board, including those in the luxury segment.

However, the increases in average rate and occupancy alone cannot explain the recent wave of interest in the luxury hotel market. The incremental boost to value for luxury hotels created by the increase in average rate and occupancy is only one minor element contributing to the huge amount of capital chasing the limited amount of luxury hotel product in 1995. Among the most significant factors leading to the on-rush of interest in luxury hotels is the fact that many major lenders (in particular, many of the Japanese banks) have begun to “write-down” their nonperforming hotel loans, which has allowed them to start taking decisive action in dealing with their hotel assets (e.g., placing some very desirable luxury product in the market with a radically lower basis).

Many industry experts believe that the Japanese banks are on the verge of taking control of the vast amount of luxury hotel assets on which they have made enormous loans in the 1980s. The authors have already seen many examples of Japanese lenders either selling their loan positions to third parties at deep discounts or facilitating a sale by their borrowers to third-party investors at a fraction of the face amount of the loan. If this trend continues this year, which the authors believe not only will occur but at an accelerated pace, the near-frenzied interest in the luxury segment will be sure to grow.

“New Generation” Investors

By all indications, many off-shore banks will be selling luxury hotels to investors at a fraction of replacement cost, thereby allowing the investors to establish a new cost basis for their hotel investments. Consequently, these “new generation” luxury hotel investors will have to generate only a fraction of those hotels revenues that their predecessors had to in order to make an adequate return of their investment.

This is, of course, one of the primary reasons that the investor community has again embraced hotels as one of the preferred investments. The amount of cash flow necessary to achieve a desired yield is but a fraction of what was necessary to achieve those yields with the amount of debt placed on the hotels in the 1980s. Additionally, the investors seem to be betting on the upside appreciation that a hotel purchase at today’s prices may provide them in addition to the current yields that can be obtained. This two-pronged investment analysis predicated upon a desired yield and potential appreciation based on a deeply discounted purchase of a substantial asset may prove to be hugely profitable for the savvy investor if appropriately counseled by hotel financial advisers and hotel lawyers.

The “new generation” luxury hotel investors will be virtually assured that no new product will come on-line in the near future given the current scarcity of financing and current cost to buy a luxury hotel versus the current cost to build a new luxury hotel. According to Paine Webber, Inc., the current cost to build a new luxury hotel is in the $250,000 per room range, while the cost to buy an existing and relatively new luxury hotel is now in the $110,000 range.

As long as this divergence between the cost to buy versus the cost to build exists, it will continue to make good economic sense for investors to seek out opportunities to purchase existing luxury hotels. According to many knowledgeable hospitality industry sources, this existing disparity in the buy-versus-build analysis will not be significantly altered for the foreseeable future. Accordingly, we can expect to continue to have a tremendous amount of interest in purchasing existing luxury hotel product.

Conclusion

The question remains, however, when will the interest in luxury hotels reach the level that financing sources and equity investors feel that it is time to put new dollars into new product and start breading ground? If history is an indicator, that time may not be as far away as many industry sources believe. Can the 1980s overbuilding occur again? Probably not with the same scope and magnitude, but some version of the same zealousness to invest in and ultimately start building luxury hotels seems almost inevitable in the final part of the 1990s.

1 Smith Travel Research, Paine Webber, Inc.

2 Id.

3 Id.

4 Smith Travel Research, FW Dodge

5 Paine Webber, Inc.