Hospitality Real Estate Execs' Confidence Shifts Into Overdrive

The beginning of a recovery last year in the hotel commercial property sector is expected to accelerate into a full-blown resurgence in 2011. Hospitality executives and analysts are expressing a surprisingly robust level of optimism, even exuberance, about market conditions this year.

Bullishness about the state of the hospitality market in 2011 was on full display at this week's Americas Lodging Investment Summit (ALIS) in San Diego. A host of hotel reports were issued in conjunction with the gathering, confirming CoStar Group's forecast last month that an improved global economy, modest U.S. job growth, and stabilizing home prices is expected to lead to a growing number of business travelers and vacationers booking a lot more hotel rooms in the year ahead. Some analysts expect average daily rental (ADR) rates to move to at least a two-year high.

Hotels took more damage than any other sector of commercial properties during the recession largely due to their exposure to volatile daily room leases, as personal and business spending plunged. The daily lease term, which made hotels "tragically vulnerable" in the downturn, is now helping hotel fundamentals recover faster and allowing owners to generate more income quickly, according to a CoStar analysis. In addition, owners will be able to resolve distressed assets more quickly than other commercial property types. Delinquencies on CMBS hotel loans appear to be turning a corner and lenders appear to be more willing to work with borrowers as values improve.

“Whereas the 24-hour nature of hospitality leases was a detriment to the industry during the downturn, it now places hospitality real estate in the best position to benefit from the improving economy,” said CoStar Senior Real Estate Strategist Chris Macke. “We expect to see continued improvement in the hospitality financing market, including hospitality properties making their way back into CMBS pools.”

In its 2011 predictions for the major property sectors by CoStar subsidiary Property & Portfolio Research (PPR), real estate economist and hotel specialist Jeff Myers said corporate travel ushered in the recovery in 2010, but increased vacation travel will lead stronger hospitality demand this year.

"Room bookings took a huge step in the right direction in 2010," Myers said in a presentation of the PPR predictions last month. "Leisure travel recovered some, but as [CoStar/PPR] predicted, it was outpaced by the return of the business traveler. However, 2011's demand story will be headlined by an uptick in vacationers."

As the economy and consumer confidence strengthens, "increasing numbers of American households will choose to reward themselves with a much-deserved vacation," Myers predicted. Global economic recovery and recent U.S. legislation promoting and incentivizing international travel to the U.S. will lure more foreign visitors.

In spite of the market confidence, occupancies are still around five percentage points below their average during the market peak in 2004-07. But conditions are surely much improved from the very deep lows of 2009. Hotel ADR and occupancies will climb in 2011, ensuring stronger cash flows for owners and investors. Hospitality values are on the upswing after bottoming in third-quarter 2010 and property-level incomes have actually been improving for about a year.

"While the industry has suffered two years of declining fundamentals and endured the drag of a global economic recession, we believe that the worst is over, and the light at the end of the tunnel is not only visible, but growing larger each day," said Michael Fishbin, leader of Ernst & Young’s global hospitality practice. "Lodging sector recovery is a fact -- resurgence is no longer far away."

In an interesting supply/demand twist, the number of rooms will rise nationally despite very little actual new hotel construction, Myers noted. Hundreds of hotels either closed or removed large room blocks from the market during the recession. For example, two separately owned hotels, the Wyndham and the Sheraton, both closed in late 2009, taking nearly 1,000 rooms off the suburban Chicago hotel market during a single week.

Owners will put many darkened hotel rooms back into their service inventories as distressed properties pass on to new owners and travel improves. Despite the new supply, room occupancies will continue to increase as travlers make more leisure, business, and convention bookings.

"Given the drop in new construction, demand growth relative to supply growth will be at a 20-year high entering 2011 and should remain healthy through the year," Myers said.

The improving picture for hotels resulted in a burst of investment sales activity last year, especially for trophy or troubled assets. Talk among some owners and operators chasing yields has even shifted to starting (or restarting) new development projects.

Starwood Hotels & Resorts Worldwide, Inc. (NYSE: HOT) announced just such an expansion in San Diego. The company and its nine brands this year expects to open more than 20 newly developed or converted hotels in North America, Starwood's largest global division with more than 530 hotels.

"The hotel real estate market in the United States is in a very different situation than other types of real estate. Despite economic woes, and even with unemployment above 9%, hotel occupancies are back at pre-crisis highs and we’re facing record-low new supply here," noted Starwood President and CEO Frits van Paasschen. "While we expect new-build activity to remain low, we are watching the transaction markets, which will fuel conversion opportunities and ultimately new hotel construction.

"We have shovel-ready projects in metro markets like Chicago, Austin and San Francisco that are ready to move forward as financing becomes more available," van Paasschen said.

All this has gives hope to hotel owners, operators and investors. According to DLA Piper's 2011 Hospitality Outlook Survey, also released this week, investors have swung decisively from bearish to bullish sentiments in the marketplace over the last 12 months. Nearly tripling the optimistic sentiments from early last year, 88% of respondents in 2011 describe their 12-month outlook for the U.S. hospitality industry as "bullish."

Nine out of 10 respondents believe that market conditions have created good buying opportunities for well-capitalized investors, led by opportunities in the upscale and luxury sectors. And 82% expect hotel asset values to rise over the next year, compared with only 20% in 2010.

Respondents expect REITs (51%) and private equity (40%) investors to dominate the U.S. hospitality investment landscape in 2011. More respondents holding troubled loans expect to have their debt refinanced or restructured this year.

Growth in corporate profits has been phenomenal and will help business travel bookings continue to gain ground, CoStar Group's Myers said. Leisure travel demand should also surge as household finances improve, putting vacations back on the radar screen.

Groundbreakings are still uncommon, and because the majority of increased demand lies ahead and the supply pipeline is thin, average hotel occupancies will be able to recover to a healthy 70% by the end of 2015, Myers said.

Investors considering individual markets will be happy to note that by the end of 2015, all but a handful of the largest 54 metros will see recoveries that propel occupancies well above their historical average, according to the CoStar forecast. Occupancies in West Coast metros will generally beat those in the Midwest.

Beyond the real estate fundamentals outlook, the performance of legacy hotel loans down the road is tied to the movements of interest rates and lending spreads.

Assuming that REITs and other hotel buyers stay interested in hotel properties and more large loans are resolved, as has emerged as a pattern over the last two or three months, it's very likely that the high CMBS hotel delinquency rate will turn the corner in the current quarter, CoStar forecasts.

Hotel profits showed considerable momentum going into 2011 as revenue per available room (RevPAR) increased year-over-year in the final nine months of 2010, according to Marcus & Millichap's First-Quarter 2011 hospitality report. Also, average daily rates rose from a year earlier in each of the last six months.

The construction drought and increasing revenues will further boost RevPAR, although many markets will not reach pre-recession peaks until 2012, when daily rates will rise more robustly, M&M said. The annual ADR will move up for the first time in two years this year as operators capitalize on increases in demand for rooms, especially in peak travel periods.

Ernst & Young expects opportunistic investors to return to the hotel sector in droves this year.

"We’ve seen a few distressed asset and note purchase opportunities in the last 12 months and we have no doubt there will be more in 2011. But we also expect to see equity investors take advantage of opportunities presented by upcoming debt maturities to purchase institutional grade assets this year," Fishbin said.

With hotels numbers and returns improving, investors will likely to want to lock in deals before the numbers get too rich and prices rise, the E&Y report suggests.