Dramatic changes hit hotel financing in 1998.  While hotel profits and revenues continued to grow, although at a slackened pace, the hotel financing picture refocused itself.  The results of PKF Consulting's 1999 Hospitality Investment Survey bear out these observations.

Major changes occurred toward the end of the third quarter of 1998, when REITs, which had been dominant players in the marketplace, effectively closed for business, and Wall Street, which had been a prime financing source, shut off the tap of capital.  Both of these factors had an effect on the investor/buyer demand base by reducing the number of players and greatly curtailing the ability to leverage transactions.

Based on the responses to the survey, we estimate that the total number of transactions occurring during the last quarter of 1998 was greatly reduced from that of the same quarter of the previous year.  The irony of the situation, however, is that the “supply,” that is, the hotels themselves, continued to experience strong levels of performance, particularly in the full-service sector, with growth in RevPAR levels substantially exceeding that of inflation in most market areas.  Thus, the curtailing of demand bore no relationship to the desirability or performance of the supply of product.

The strong performance of the full-service hotel sector has been aided by a lack of new supply additions, due to the comparatively higher costs and increasingly difficult barriers to entry in many market areas.  On the other hand, the limited- service sector is experiencing substantial new development, notably in the economy-oriented, extended-stay segment.  As a result, a supply/demand imbalance in the limited-service sector is an increasing possibility.  With strong growth in limited-service supply, transactions involving existing limited-service product have been affected accordingly.

With REITs and Wall Street effectively out of the market, financing for new projects will have to come from more traditional sources, such as banks, with typically more conservative underwriting criteria and comparatively higher financing costs.  As - and if - financing becomes more “costly”, new development activity will be increasingly limited, a condition which, thankfully, might preserve a more tolerable supply/demand balance.  Such a scenario would be a good example of the market correcting itself, and if carried out, would do much to prevent an industry disaster like that of the early 1990s.

The results of the investor survey bear out these observations.  The most frequently cited investment measures, capitalization rates and yield rates, or IRRs, were lower in 1998 than in any year since 1990.  In other words, hotel investments were more desirable in 1998 than they had been for the preceding eight years.  Related statistics, such as the average holding period and loan interest rates, were similarly indicative.  However, loan-to-value ratios were at their lowest level since 1986, which is somewhat contradictory to the other trends, and speaks to the more “costly” financing mentioned above.  Basically, it says that lenders, who more and more frequently are banks, are requiring more equity in the projects in which they are involved.

The following paragraphs highlight some of the other findings of PKF Consulting's  1999 Hospitality Investment Survey.

• The continued strength of the full-service hotel sector is reflected in the lower capitalization and yield rate requirements, compared to the limited-service sector, with its comparatively longer holding period. By virtually all measures - lower return requirements, longer holding periods, higher revenue multipliers, and shorter marketing periods - the desirability of the full-service sector as an investment vehicle is well demonstrated.

• The full-service sector generally commands lower interest rates and slightly longer terms than the limited-service sector.  Amortization periods and debt coverage ratios, however, are comparable for both sectors, while loan to value ratios are lower for the full-service sector, an unexplained anomaly mentioned previously.

• When asked to rank their preferences for various valuation techniques, the most favored techniques were based on some relationship to income or revenue, as is generally true of virtually all investments where economic returns are of paramount importance.  An interesting exception - percentage of replacement cost, an oft-quoted measure of price/value - was considered only moderately important by the respondents.  Both Direct Capitalization of NOI and Discounted Cash Flow remain the most two most important valuation techniques, which has been the case for a number of years.

• Regarding the foreseeable future of the hotel industry, the respondents were optimistic.  Revenue is projected to grow at 4.2 percent annually, while expense growth is expected to approximate that of inflation, or 3.0 percent annually.  The result is projected “bottom line” growth of just under 5 percent per year, comfortably above inflation.

• The capitalization of existing (“trailing”) cash flow is the most used technique is the most frequently used cash flow when performing a direct capitalization exercise.  Before capitalizing income, the majority of respondents (92.5 percent) first deduct a reserve for capital replacement.

• Regarding the level of interest in property types, the full-service segment again receives high marks, with 83 percent of prospective buyers expressing interest in this product type in 1998 - 99.  The situation is reversed in the developer sector, with the majority of developers (56.5 percent) expressing interest in the limited-service segment, corroborating our earlier observation of a possible supply/demand imbalance in this segment.

Of course, the life-blood of the hotel industry is the traveling public - for business and/or pleasure.  And travel trends are largely a function of the general economy, which, more than anything, has fueled the success of the industry over the past several years.  Absent any dramatic swings in the economy, the hotel industry should continue to experience positive levels of performance.

The results of PKF Consulting's 1999 Hospitality Investment Survey were based on responses from 54 respondents involved in a total of 435 transactions during 1998.  To purchase a copy of the survey, contact the Research Department of PKF Consulting at (404) 842-1150.

Lawrence E. Henry, MAI practices in the Philadelphia office of PKF Consulting.