This is an HTML version of a story that ran in the May issue of Real Estate Forum. To see the article in its original format, click here.

Sending a message that it is recovering and then some, the hotel sector's strength is now at Herculean levels. The top tiers are slightly less fertile for investment than the lower-priced chains but overall, the industry is having a golden moment.

“It's a good time to invest in the industry,” says Robert Mandelbaum, director of research information services at PKF Consulting. “In fact, it's one of the better times.”

“There's not a lot of new competition in 2013 and 2014, which will perpetuate the growth in occupancy,” he continues. “That allows hotels to drive prices, and they are benefiting from the ADR.”

Benefitting indeed. In a March report, PKF Hospitality Research predicts domestic hotels will experience a 6.1% increase in RevPAR for the year, prompting a staggering 10.2% rise of NOI.

An owner's first-hand experience supports these claims. “Since the start of the year we've seen fairly strong operating performance in all segments of hotels across our portfolio,” says Tyler Henritze, a senior managing director in Blackstone's real estate group. “Q1 has met or exceeded expectations.”

These positive forecasts, and first-hand experience, stem from astounding occupancy levels as well as a dearth of new supply, according to several industry analysts.

“We're seeing some of the most favorable operational metrics today than we have in a long time,” says Gregory LaBerge, national director of Marcus & Millichap's national hospitality group, as previously reported in Real Estate Forum's sister publication, GlobeSt.com. Further, “This will go on for the next several years. Over the past few years, we've seen some of the lowest numbers of new hotels coming on line.”

Supply was muted, LaBerge explains, but demand soared, with 2012 posting record room sales of nearly 1.1 billion nights. “And we're supposed to blow through that again this year.”

Agrees Jan Freitag, SVP at Smith Travel Research, “In the first three months of this year, the industry made more room revenue, at $27 billion, than in any other first quarter.” This positive moment will likely continue for some time, he adds.

“While the number of existing rooms—which is 1.8 billion—is higher than it's ever been, it's growing at a pace that's lower than its ever been,” says Freitag.

Although it's not at levels that threaten current supply and demand dynamics, the pipeline is healthy. According to Lodging Econometrics, the total pipeline consists of 2,757 projects with 431,204 rooms. New York is the top market, with Washington DC and Houston following suit. From one management company's perspective, growth is happening at a good pace.

“Our pipeline looks fantastic,” says Bill Fortier, SVP of Americas development at Hilton Worldwide. “We added more than 500 properties last year, we could add 600 this year and possibly 700 in 2014.”

It's not a bad time for those looking to break into hotels to consider building, he suggests. “It's cheaper right now to build than to buy.”

Still, the pace of growth in the market is far from a rapid clip, Freitag notes. “The long term average is 2.1% and we're at 0.6% for 2013. This is the lowest level of construction we've ever seen.” The pace is lending an assist to pricing, he adds. The slow growth “means occupancy has to go up, and that gives you pricing power. For the first quarter, occupancy was 57.7% and ADR was $108.” By contrast, according to PKF data, occupancy was 56.7% for Q1 2012, and ADR was $103.

But if an asset class is so popular, can a buyer get in? “That's the problem,” admits Freitag. “We're expecting room rate and RevPAR growth in the next 24 to 36 months to be rate-growth driven and that'll drive NOI, which should then drive real estate values.”

Players in the market and analysts alike feel the best bang for a buck in the hotel sector right now is limited- (also known as select- or focused-) service hotels.

“Focused service is the darling of the industry right now,” declares Fortier. “Big private equity funds finally figured out that there's more to be made in focused service than full service,” he asserts. “There's better long-term return and less risk because there aren't costs for food and beverage service and the like, which can be expensive to maintain.”

In addition, he says, “Focused service, which has very little debt, doesn't have much swing in its EBITDA, whereas full-service properties have a lot of fluctuation because of food and beverage sales and group room nights,” asserts Fortier. “That's the category of spend that falls off dramatically in a downturn.”

At least one such brand from Hilton's portfolio, Hampton Hotels, is a good example of the success of this hotel segment. The chain opened 22 new properties—adding 2,134 guestrooms—in the first quarter, kicking off an expected 90 openings this year. In 2012, 70 Hampton Hotels made their debut.

“We target select-service hotels because they are a more efficient and less-complex operating model with stronger margins,” adds Greg Merage, CEO of MIG Real Estate, which recently purchased its fourth such property in the Tampa, FL area, “and they offer a much lower investment cost per room compared to their full-service counterparts. Within this category, we like the 'power brands'—such as Marriott, Hilton, IHG, Hyatt—because of their robust marketing engines and successful loyalty programs.”

And limited-service hotels still pack plenty of value, Mandelbaum says. “There's a lack of availability at full-service hotels with the high occupancy levels, so people have to seek rooms in lower priced properties.” Also, he noted, “as the top-tier hotels drive rates up, people will trade down because of price, so lower-priced properties will do better, too.”

Several other industry participants note though that full-service assets, in a somewhat distressed condition, are also a great buy right now.

“Rarely today can you can develop a full-service property without both public and private funding, so there's a barrier to entry,” notes Scott Smith, SVP at PKF Consulting. Instead, “we're seeing investors buy full-service properties that may require significant product improvement plans (PIPs)for renovation to maintain or retain their brand. It can be a price break of 15% to 25%.”

He continues, “Maybe the existing owners didn't have the capital to do the PIP or they couldn't get funding. If they bought at 2006 inflated rates, they may have a five- or seven-year mini perm and they're not making money, so they walk or they might try to sell.”

Adds Blackstone's Henritze, “Generally speaking, given our cost of capital, we focus on properties that need fixing where maybe the previous owner wasn't able to invest the appropriate level of capital. These assets often are underperforming their competition so we work to address those challenges and then sell the asset.”

And even in this healthier economy, there are still distressed properties in need of new ownership, he says. “Today there are not as many deep distressed situations, such as bankruptcy, as there were several years ago but there are still many opportunities where owners do not have adequate capital to invest in their assets appropriately and we choose to focus on these situations.”

Adds Fortier, “There have been a lot of full-service properties that have been neglected as focused service becomes the focal point. They're in an area or market where they can't be a Hilton, or a higher-level hotel, because the PIP would be too expensive for them,” he says. “A DoubleTree by Hilton still would be 3.5 stars and it's a frame that costs less than a Hilton full-service hotel.

“As they are,” he continues, “these hotels are earning a 60% to 70% share of RevPAR, so they're low in this market, but under the DoubleTree brand they can move to a 100% to 110% market share.”

By Fortier's account, several investors have caught onto this opportunity. “We did 31 re-flaggings to DoubleTree in the US last year, and we will do the same this year. If you buy a small full-service property now, you'll be ahead of the next wave when it comes,” he contends.

Merage sees the benefit of these properties even in the current market. “We will entertain smaller full-service products with a modest food and beverage operation,” he says. “These often can compete very well in urban environments.”

Ultimately, the choice of investment type usually comes down to the type of buyer on the deal, says PKF's Smith. “If you're a large institutional investor looking to do a $50-million deal, then you'll gravitate to full service. If you're a private equity firm or a pension fund, then you'll go to properties that are $15 million to 30 million,” he says. “There are more of those available.”

Still, it's tough to make a bad choice in the current market, notes Mandelbaum. “We don't think there are bad segments to invest in, some just are better than others.” Agrees Merage, “The basis and cap rates for hotels, relative to other property types, remain very attractive. Financing for hotels also has become very competitive; we're seeing terms that rival what was being done before the recession.”

Of course, the value of the asset, and wisdom of investing, is also determined by real estate's most basic tenet: location, location, location. That, and who's doing the investing, says Fortier.

“The big money wants to be in big city markets, either in their downtown areas or wherever the action is,” he says. Rate growth there would make anyone anxious to enter the fray, says Freitag, noting activity in one market as an example. “If you try to get a luxury room for $290 in New York City, they'll laugh you off the island. Occupancy there is 70%, that means seven out of every 10 rooms are booked, on average.”

But the smaller markets have appeal for buyers too, Fortier notes. “We're still doing a ton in small markets. There's a huge boom in the Dakotas, West Pennsylvania, West Texas; it's wherever there's oil. In the past, if we opened one hotel in North Dakota in seven years it would be a lot,” he notes. “Now, we can open seven hotels a year there, if not more.”

Markets that have been on the map before are of interest too, he says. “People thought inventory would be dead in Miami because of the overbuilding of condominiums but now people are talking about new development. Also, there are selective areas on the West Coast and in the Northeast where if you can combine retail, office and residential property, there is some development taking place.”

In addition, Fortier says, “we're seeing movement in RFP markets [i.e. cities that are seeking to build a hotel at their convention centers]. This is happening in Miami, Chicago just called for one and New York City is talking about one for Manhattan.”

Smith calls out Miami, Austin and New Orleans as hot, as well as gateway markets such as New York, Boston, Washington, DC and San Francisco.

Freitag also is bullish on San Francisco. “San Francisco hasn't seen any supply growth and there's nothing under construction; the market is super hot.” Meanwhile, he adds, “Oahu is just on fire. Occupancy there is 90% almost every single night.”

At Blackstone, hotel investment is generally done on a case-by-case basis but some spots in Hawaii caught the firm's attention, notes Henritze.

“We were focused on Oahu and Waikiki because of the very strong supply and demand fundamentals,” he says. “As has been reported, we are under contract to buy the Hyatt in Waikiki, the deal likely will close in mid-July. We plan to invest in excess of $75 million to update rooms and common areas, and it sits on 100,000 square feet of retail that we are evaluating.”

Hotel investors nationwide can expect healthy profit growth for the foreseeable future, says Mandelbaum. “The outlook is positive. Not only is revenue growth being driven by ADR at this point in the cycle, which is very profitable for investors,” he notes, “but after previous recessions we've seen surges in expense growth during the first few years of recovery as managers replace the services and amenities cut during recessions and bring back employees who were cut or had their wages and/or hours reduced.”

During this recovery though, Mandelbaum contends, “We actually have seen a continuation of the austerity practices of 2008 and 2009, and expense growth has been fairly modest. It's not surging like after past recessions, so there's growth at the bottom line,” he says. “I think technology and efficient staffing are helping to perpetuate the limited cost spike.”

Overall, Mandelbaum predicts, the trajectory for hotels is good on a number of fronts. “We're expecting both rate and revenue growth in 2015 and 2016. We will see a slight decline in the pace of growth in 2017, but that's mostly due to the cyclical nature of the industry,” he contends. “The prospects are good for hotels.”

Want to continue reading?
Become a Free ALM Digital Reader.

Once you are an ALM Digital Member, you’ll receive:

  • Breaking commercial real estate news and analysis, on-site and via our newsletters and custom alerts
  • Educational webcasts, white papers, and ebooks from industry thought leaders
  • Critical coverage of the property casualty insurance and financial advisory markets on our other ALM sites, PropertyCasualty360 and ThinkAdvisor
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.

Rayna Katz

Rayna Katz is a seasoned business journalist whose extensive experience includes coverage of the lodging sector, travel and the culinary space. She was most recently content director for a business-to-business publisher, overseeing four publications. While at Meeting News, a travel trade publication, she received a Best Reporting award for a story on meeting cancellations in New Orleans during Hurricane Katrina.