Today's hotel market is thriving, competitive and bullish. It's also a day late and a dollar short, overleveraged and obsolete. In fact, how the hotel market is functioning really depends on where you are. Are you in New York City or Tahoe? San Francisco or Las Vegas? The gateway cities are wheeling and dealing, driving market rates higher and cap rates lower, in a way that resembles 2007. REITs are shouldering their way to the front of the line for trophy properties and top-of-the-line distressed product coming out of servicers. Meanwhile, physically degraded properties continue to drop flags and beg for reuse or to be put out of their misery altogether. The meat of the market is left in the middle or lower ends for savvy, capitalized investors who are willing to go farther a field to find opportunities.

"Nobody ever wants to trade in a down market," says Daniel Lesser, president and CEO of LW Hospitality Advisors. "Now that we're solidly in a rising market, end users are taking action, and you still have an enormous amount of debt that will be coming due here in the next 18 to 24 months." The question, he points out, is how much money will be available for specific deals. "There are still legacy issues that haven't been dealt with. They will expand all the asset classes in all the hotels. By no means are we done with the class A stuff . Frankly, you're going to see more of it come around now that we're in an up market and there is a clear marketplace definition of what assets are worth."

The St. Regis Hotel in Washington, DC stands out as an available distressed trophy. Having recently dodged a foreclosure auction, it is still being shopped around by Barclays Capital, which foreclosed on the $25-million mezzanine piece in early April of this year. This, after the Irish private equity firm Claret Capital purchased the luxury hotel for $170 million in 2007. Speculation has the hotel selling for possibly $90 million to $100 million.

And the recent Innkeepers USA portfolio grab by a partnership of Chatham Lodging Trust and Cerberus Capital Management is exciting the market. The coup grabbed 64 hotels for $1.125 billion through a bankruptcy auction. Emblematic of the times, Chatham president Jeff Fisher was formerly the CEO of Innkeepers USA, leaving Innkeepers in 2007 after a peak-market sale of the same portfolio to Apollo Investment Corp. to the tune of $1.5 billion. But in the summer of 2010, Innkeepers filed for Chapter 11 and in January of 2011 began looking for bidders.

The thought of lapping up the St. Regis at a bargain was the goal of every vulture fund two years ago, but now it's closer to a pipe dream. As REITs squeeze the market with low-cost capital, investors whose access to cash is not so easy must seek opportunities elsewhere in ever-shrinking markets.

"The opportunity is now in the secondary and tertiary markets," says Atlas Hospitality Group's president, Alan Reay. "The main gateway cities' values have rebounded very strongly. Revenues are way up and very few opportunities are available to pick up distressed assets." The economic bounce in hotels is a small boon for hoteliers, but lenders noticed and have been taking properties back at a slower pace, barely moving the needle for REO to $4.5 billion in Q1, notes Real Capital Analytics. As a result, there will be less distress to go around for investors.

But if opportunity is the goal, investors can dig deeper than Reay suggests. It is a matter of math and derring-do to discover opportunity outside of the distressed trophy and secondary markets. "There are lots of folks that can make money on beat-up, physically and functionally obsolete hotel assets at the right basis," he notes.

"There clearly is no shortage of functionally obsolete hotels throughout the United States," says Lesser. Many hotels were built as part of the burgeoning highway system in the US, which, as Lesser observes, were great sites during the Eisenhower administration. The key to some of these will be renovation or reuse.

"We get contacted by a lot of people wanting to repurpose hotels," Reay says. "We're actually seeing some of the older hotels sit on quite a bit of land. Let's say it's an ex-Holiday Inn with 200 rooms on five or six acres. That new buyer may come in and decide to reduce that room count and either put up two smaller, newer hotels or some retail but keep some part of the original hotel component." Common reuses for hotels are seniors housing or multifamily, if the properties are worth keeping at all.

The famous adage of US hotels goes, "We are not overbuilt, we are under-demolished." And it may be that many lenders will have to bite the bullet on some upside-down properties, sell them for the price of the land and eat the demolition costs. Lesser says that this is a problem in many of the secondary and tertiary markets that look like good investments now. The problem, as always, is timing. "The hotel market is famous for boom and bust," Lesser says. He points to the metro-suburban sectors of markets such as Phoenix and Dallas, which are susceptible to speculative overbuilding. "Development radiates out," he says, "and you see a lot of those markets get discovered and then rapidly overbuilt." So as investors delve into these secondary and tertiary markets, caveat emptor. If you're on the right part of the curve, you win. If not, your hotel might be worth less than the land it ends up on in a few years.

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