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Second-Tier Hotel Markets Are Likely to Outperform
First-Tier Markets for Remainder of the Decade
NEW YORK, November 27, 2006 - Hotel investors seeking the highest risk-adjusted returns should now focus their attention on the second-tier hotel markets, according to Hotel Investment Strategies, LLC, a lodging investment advisory firm based in New York.  

The top twenty-five hotel markets include markets such as New York, Chicago and Los Angeles as well as markets such as Denver, Detroit, Baltimore and San Diego. The second-tier includes markets such as Austin, Cleveland, Indianapolis, Omaha and Richmond. 

On a risk-adjusted basis, a portfolio of second-tier hotels outperforms a portfolio of top-tier hotels in the mid to later stages of the up-cycle, whereas the top-tier portfolio outperforms the second-tier portfolio in the contraction, recession and early stages of the up-cycle.  
“Now that we are in the mid to later stages of the up-cycle, a portfolio of small city full-service hotels is a valuable addition to a large-city-only portfolio, both as a return enhancer and a risk diversifier,” said Ross Woods, Principal of Hotel Investment Strategies. 

“Conversely, a portfolio of large city full-service hotels is a valuable addition to a portfolio of mainly small city full-service hotels in the contraction, recession and early stages of the up-cycle.” 

The firm back- and forward-tested both the top-tier and the second-tier hotel portfolios to determine the historical and forecast portfolio returns by assuming that each market is equally weighted in its respective portfolio. 

“On a five year rolling basis, the top-tier hotel portfolio generated a marginally higher average annual RevPAR growth rate at 3.5% for the period 1992 to 2005 compared to the second-tier portfolio at 3.2%”.  However the top-tier hotel portfolio experienced higher average risk at 4.4% per year compared with 3.6% for the second-tier hotel portfolio. Therefore, on a risk-adjusted basis, the second-tier portfolio marginally outperformed the top-tier portfolio,” said Mr. Woods.

“Over the next four years the top-tier portfolio is likely to provide higher RevPAR growth rates but be burdened with higher risk. On a risk-adjusted basis the second-tier hotel portfolio is likely to outperform the top-tier portfolio for the remainder of the decade.” 

Mr. Woods said the key to higher returns over the next few years is to spot those small cities that will grow much faster than average. “The challenge for investors is to find suitable hotel assets in the second-tier markets.  While the country has about 4.4 million hotel rooms, 19.5% are full service in the top 25 markets and only 6% are full service in the next 25 markets. The biggest issue facing investors in the second-tier hotel markets is illiquidity and this should be factored into the purchase price.” 

In the same way that many stock investors rotate between sectors based on their assessment of the state of the business cycle, hotel investors should do likewise. “The idea is to shift the portfolio more heavily into markets that are expected to outperform based on forecasted risk-adjusted returns,” said Mr. Woods.  “Sector rotation, like any other form of market timing, will be successful only if an investor anticipates the next stage of the hotel cycle better than other hotel investors.” 

“Smaller hotel markets are less correlated with large markets, making them excellent candidates for diversifying a large-market-only portfolio,” said Mr. Woods. “Furthermore smaller hotel markets have low correlation with themselves which means that even when a hotel fund is of limited size, a well diversified portfolio can be constructed because there are a large number of full-service hotels in smaller markets.” 

While the competition for large city hotel assets has been intense in recent times, many REITs have targeted smaller cities.  “It appears that hotel REITs own more properties in these markets compared with their private counterparts.  While small hotel markets are attractive to many REITs, they are being overlooked by many institutional investors who have been concentrating their acquisitions in the top 20 metropolitan areas in the country,” said Mr. Woods. 

About Hotel Investment Strategies, LLC
Hotel Investment Strategies, LLC is a lodging investment advisory firm that helps clients construct and manage hotel portfolios that provide the highest levels of return for any given level of risk by harnessing the power of Modern Portfolio Theory. 


Ross Woods
Hotel Investment Strategies, LLC
410 Park Avenue, 15th Floor #759
New York, NY 10022
Tel: 212-308-2192

Also See: San Antonio Hotel Occupancies May Reach 75% in 2007; Higher then Any Other Texas City / November 2006
Hospitality Industry Top 10 Thoughts for 2006 / Ernst & Young / January 2006

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