The Investors Choice

The set-backs to San Francisco�s economy have been well chronicled. Its underlying fundamentals are so compelling that it ranks as one of the nation�s key "buy" markets. It is down, but not out.

The San Francisco Bay Area is comprised of nine counties of over 6.8 million people with the nation�s highest household income. The region benefits from its top universities, an innovative business community and its natural beauty. The city of San Francisco is recognized as an international business center, the financial hub
of the West Coast, and maintains its status as the cultural and intellectual core of the Bay Area.

The Bay Area, headquarters to 25 of the nation's leading Fortune 500 companies, already has the world-class infrastructure and economic base in place to facilitate the upcoming recovery. As the regional economy recov-ers, the Bay Area is expected to once again attract a highly educated and affluent work force in the technology, finance, biotech, and the law sectors, all potential demand generators for the area�s hotel markets.

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The following map graphic indicates our expectations for San Francisco and other major cities throughout the United States in 2003. The results are somewhat beguiling as many of the major markets are forecast to achieve "some" growth rates. But this is more a reflection of how significant the downturn in these markets was in 2002 compared to the national average, as opposed to any spectacular "real" growth rates. In many cases, such as San Francisco, growth rates will barely lift major cities to even 1997 levels.
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Source: Jones Lang LaSalle Hotels

According to the San Francisco Convention & Visitors Bureau, the Moscone Expansion Project is currently underway and expected to be completed by July 2003. The project involves an addition of approximately 300,000 square feet of net meeting space divided among 38 meeting rooms increasing the Moscone Conventions Center�s total capacity to close to 902,000 square feet of net exhibit/meeting/banquet space upon completion.
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Inventory

The San Francisco MSA hotel market consists of approximately 49,000 rooms in 360 properties. The market area includes the City of San Francisco, as well as San Mateo County to the south and Marin County to the north. The distribution of the market�s room inventory is presented in the following table.

Convention center hotels, comprising approximately one-third of the city�s total room inventory, dominate the San Francisco hotel market. The luxury hotel segment, in turn, has the lowest share of product, but boasts the highest barriers to entry.
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Seven hotels with a total of 1,994 rooms opened in San Francisco between 1999 and 2002. Only two properties are currently under construction, the 252-room Argonaut and the 276-room St. Regis Hotel, both expected to open by the end of 2003. Carpenter & Co. is building the St. Regis Tower, which includes 100 condominiums atop the 276-room Starwood-brand hotel. Hotels with condominiums are common on the East Coast, but have only recently arrived to the western United States.

Despite significant barriers to entry, and as presented earlier seven (and one expansion) were already added to the city�s inventory over the last four years. Given the current uncertainty in the lodging and capital markets, it is unlikely that the planned/proposed properties with a total of 2,715 rooms will materialize, supporting the notion that the San Francisco hotel market wil not be in a position to absorb additional new supply until 2006 at the earliest.

Foster City Enterprises� Bloomingdale's hotel project in San Francisco, which Le Meridien was pursuing, has been abandoned due to financing challenges. Forest City still has the planning/building rights for a large mixed-use development project on Market Street in San Francisco, including a 365,000-square-foot Bloomingdale's, 375,000- square-foot of upscale shopping, 235,000-square-feet of Class A office, and a 435-key hotel.

Market Performance Levels

Factors indicating that San Francisco�s performance will once again strengthen include the following:

• The Bay Area is the headquarters to some 25 of the nation�s leading Fortune 500 companies, and is expected to continue to attract a highly educated work force in finance, bio-tech, and legal;
• The Bay Area is expected to reinvent itself by establishing the region as a world center for nanotechnology (molecular-scale manufacturing);
• SFO passenger volume is expected to increase significantly, with forecast volume reaching 51 million pas-sengers by the year 2008;
• The city�s percentage-point premium in occupancy remained at, or above, the national average by more than five points between 1995 and 2000;
• The underlying strength of the Bay Area�s highly diversified economy;
• Capital investment in Silicon Valley (55 miles to the south) should increase next year with a rebounding U.S. and global economy;
• Defense and homeland security spending will bolster research and development work in Silicon Valley, all potential demand generators for the area�s premier lodging assets;
• The region already has a world-class infrastructure and economic base in place that will assist in the upcoming recovery;
• San Francisco continues to be perceived as a world-class destination for leisure travelers and convention planners;
• High land costs will continue to limit new hotel supply;
• The difficult development process and related Bay Area political constraints will constrain new supply; and
• The $191 million, 300,000 square-foot expansion at the Moscone Convention Center will be completed by July 2003, with a strong convention calendar already on the books.

With high payroll costs, operating margins for San Francisco hotels tend to be slightly lower than other cities in the U.S., especially for full-service properties, which are further "burdened" by food and beverage operations. Boutique hotels and extended-stay products tend to fare much better.
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A major wave of new hotel development took place in the San Francisco Bay Area during the halcyon years of 1998, 1999 and 2000. New construction is virtually at a standstill given the dismal market conditions. One of the most recent properties to be built in the Bay Area was the 280-room Hilton Santa Clara, which opened in December 2000 at approximately $118,000 per key in development costs. The Four Seasons in East Palo Alto is currently under construction at $1.1 million per key.

Transactions

While investors are currently negative concerning the short term trading performance of San Francisco, reflective of its exposure to the tech sector, the city is among the top five markets expected to enjoy the largest turnaround in trading performance between the short and medium term. Given San Francisco�s longstanding prominence in the convention and leisure travel segments, the current decline is not expected to presage an enduring collapse like the 1980s.

In a show of confidence in the stability and long-term strength of the market, and according to the most recent Hotel Investor Sentiment Survey (HISS) by Jones Lang LaSalle Hotels, approximately 47% of investors indicated that they want to buy hotel assets in San Francisco. However, as it takes both a motivated buyer and seller to execute a transaction, sellers in San Francisco are still scarce.
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Pertaining to the Courtyard by Marriott transaction, CNL acquired a 50 percent interest in the property through a joint venture with an affiliate of Marriott International. This joint venture financed the $82 million acquisition with equity investments of $13 million from each of CNL and Marriott, as well as $41 million of borrowings from a third-party lender, and $15 million of mezzanine financing provided by Marriott. CNL then leased the property to a subsidiary organized to qualify as a taxable REIT subsidiary (TRS), which entered into a long-term management contract with Marriott International.

In San Francisco, as in other markets nationwide, the funding void left by the absence of Wall Street will continue to be filled mostly by private equity and institutional capital. Increasingly, investors are discovering that hotel real estate investments held by private equity funds hold a number of advantages. First, they generally provide investors with relatively steady cash flows while also taking advantage of many of the tax-efficient features of real estate investing, namely significant depreciation and interest expense write-offs, while freeing investors from the hassle of owning and managing real estate assets. Second, with properly placed investment choices, lodging real estate investments often can yield significant asset appreciation.

Although hotel financing in the Bay Area is extremely difficult to attain, lenders are still providing leverage and borrowers who have experience will find financing much easier to obtain. For example, Jones Lang LaSalle Hotels recently secured a construction loan for mixed-use luxury development in northern Napa Valley.

In San Francisco, a city celebrating both shrewd finance and high romance, it is evident that until the overall economic conditions improve, many hotel investment groups will continue to hold off on their strategic real estate decisions.

All variables considered, San Francisco will always be a world-class destination that offers its business and leisure travelers tremendous variety. However, San Francisco has demonstrated over the last two years that, albeit diverse, it has an extremely cyclical hotel market, lacking the depth of such cities as New York City or London. The coming months will be, without doubt, telling in terms of whether the San Francisco lodging market has actually "bottomed-out", or whether the worst has yet to come in light of current geopolitical events. All hopes are on the former, not the latter, with "survive until 2005" being the underlying motto.

About the Author
Anwar Elgonemy is an Associate in the San Francisco office of Jones Lang LaSalle Hotels who has extensive lodging investment experience throughout the Bay Area and Northern California. He has been involved with notable area assets such as the Hilton Hotel & Towers, Renaissance Parc 55, Claremont Resort & Spa, and the Ritz-Carlton Half Moon Bay. Elgonemy�s Northern California client base has included Citibank, Clement Chen & Associates, HCV Pacific Partners, Kimpton Hotels & Restaurant Group, The Pebble Beach Company, Stanford Hotels Corporation and Tokai Bank, among others.  Elgonemy is both a licensed commercial real estate appraiser and a sales agent. He is regularly quoted in the San Francisco Business Times and the San Francisco Chronicle, and has provided industry insight to a number of San Francisco television channels such as CNN's local edition, KRON and Fox News.

Jones Lang LaSalle Hotels is the largest and most qualified specialist hotel investment banking services group in the world. Through our 18 dedicated offices and the global Jones Lang LaSalle network of 6,000 professionals across more than 100 key markets on five continents, we are able to provide clients with value-added investment opportunities and advice. In 2002, our success story includes the sale of 6,474 hotel rooms to the value of US$862 million in 36 cities and advisory expertise on 116,877 rooms to the value of US$17.8 billion across 170 cities.

The majority of active investors worldwide have bought or sold hotel and tourism real estate through Jones Lang LaSalle Hotels, taking advantage of our extensive professional relationship and innovative strategies. Our experience and success also extends to the other services, including mergers and acquisitions, valuation and appraisal, asset management, strategic planning, operator assessment and selection, financial advice and capital raising, and industry research.