As 1999 still finds the San Francisco Bay Area in the midst of a rapid economic expansion, real estate development has been responding vigorously. Hotel developers have been building in response to strong room rates and high occupancy levels. Nevertheless, "a savvy real estate investor should always be looking at the pertinent indicators and market fundamentals, as the good times don’t last forever," says Anwar R. Elgonemy, an Associate with PKF Consulting, who compiled the report. 

International & U.S. Economy and How it Affects the Bay Area 

• The U.S. economy has remained strong despite the recent economic crisis in Asia, the upheaval in Russia, and uncertainties in Europe and Latin America. This resilience has been attributed primarily to the Federal Reserve’s highly effective management of interest rates, coupled with low unemployment (4.2 percent in 1998) and low inflation (1.6 percent in 1998). 

• Ramifications from the indicated world events have had only a mild impact on the Bay Area, as the state’s expansion industries, including telecommunications and data communications, outweighed the decline in Asia-bound exports felt by computer chips, semiconductor equipment, and agricultural products. As a result, the Bay Area’s overall economy remains balanced in 1999.

• The Bay Area, with its highly diversified economy fueled by the high-tech, biotech, and tourism sectors, has remained strong. However, the Bay Area’s unique economic vitality is not perfect, and the region has weaknesses to overcome. The following table highlights the primary positive and negative attributes of the Bay Area economy today, impacting the region’s real estate investments arena.

Demand Profile

• The individual business traveler market segment is comprised primarily of visitors to local companies, independent sales people, employees in training, and other business people associated with firms in the Bay Area. The demand for rooms in this segment is at its peak from Monday through Thursday.

• The group meetings segment primarily includes corporate meetings and convention business generated by citywide functions held at the Moscone Convention Center and the San Jose Convention Center.

• Leisure travelers include national and international visitors to San Francisco attracted to the Wharf for its tourist attractions, waterfront location and convenient access to other parts of the City. This segment also includes domestic, European, and Asian tour groups, which tend to be high in the summer and fall months. The level of tourist activity in San Francisco is closely related to fluctuations in the national economy and the strength of the dollar against foreign currencies. Leisure demand is more rate-sensitive than the commercial and group meetings segments.

Several factors indicate that the Bay Area’s occupancy premium will continue: 

• Following decreases from 1989 through 1991, the Bay Area’s percentage-point premium has remained at, or above, the national average by more than five points since 1995;
• The underlying strength of the Bay Area’s highly diversified economy; and
• The Bay Area in general, and San Francisco in particular, continues to be perceived as a world-class destination for leisure travelers and convention planners.

The San Francisco Bay Area is a market with a limited amount of available land for new construction, which indicates that new-build and conversion opportunities within San Francisco are still attractive development options. Given the strong interest in new hotel development, coupled with the Bay Area’s position as a world-class destination, we have assumed that it is highly likely that all of the indicated planned projects will materialize. 

Hotel Sales 

With occupancies and average daily room rates still strong in most of the nation’s markets, expense efficiencies achieved by hotels have allowed the improved margins to flow into net operating income, heightening the attractiveness of lodging properties as an investment category. Despite such favorable underlying operating fundamentals, underwriting parameters for hotel acquisitions are very restrictive. However, such confining parameters have not deferred the turnover of lodging assets in the Bay Area, the nation’s "nirvana" economy. 

The question is, will this turnover in California’s hotel assets continue throughout 1999 and into 2000? Within the hotel industry’s financial sector, there is still a concern that the easy money has already been made, and that the growth and momentum investors have sold their positions and have not yet been replaced by value investors. Yet, as REIT companies are being forced to sell because of their declining stock prices and expensive capital, more affordable hotels compared to last year’s prices will be placed on the California market over the coming months. In addition, it is expected that capital should become more available by the beginning of 2000, as hotel owners’ valuation expectations become more realistic, and the dynamics of capital supply and demand once again interact in a more rational manner. This means that the Golden State will see another strong year for hotel transactions, continuing to be the place where national trends are defied. 

Hotel Land Sales 

Land in the Bay Area is expensive given the complexity and difficulty to obtain governmental entitlements for hotels. On the positive side for hotel owners, elevated land values in the Bay Area result in commercial lodging remaining in short supply. This barrier to entry creates a limit on supply that tends to keep market occupancy rates and ADRs high, even during downturns in the economy.  
  
Where are the Opportunities? 

• Cycles directly affect financial performance by influencing market rents and the ability to sell for a satisfactory price, if at all. This influence can be traced to the fundamental factors of capital availability, supply and demand, and expectations. Each has a different role in the expansion and contraction phases of market cycles.

• The vast majority of the Bay Area’s primary hotel markets are in an expansion mode, with some areas showing slight signs of a slowdown.

• More traditional investors and lenders will return to fill the void that the rapid exit of REITs and CMBS conduits created in the market.
• Well-capitalized private investors and funds will become more active.
• Stable occupancies levels, but a tapering-off in ADRs.
• Required returns and capitalization rates will continue to be pushed higher as a result of more expensive debt, coupled with the more stringent underwriting requirements of these private and institutional capital sources.
• REITS will play a much lesser role as they no longer have the capital to be major buyers, and they may become net sellers.