Industry Update
Editorial Article19 January 2005

Hospitality Industry's Top 10 Thoughts for 2005

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Ernst & Young

1. Hospitality Investing: What a difference a year can make.


Improved hotel operating performance over the past year – and the anticipation of continued improvement for the foreseeable future – has led to positive investor sentiment and increased capital markets activity in the sector. According to a recent report issued by Principal Real Estate Investors, Real Estate Research Corp., and Torto Wheaton Research, unleveraged average annual returns for full-service hotels are anticipated to exceed 13 percent over the next 10 years, with real estate investment alternatives performing at single digit growth rates (approximately 7 percent to 9 percent). As annual returns in lodging are anticipated to be greater than for other real estate asset types, real estate investors appear to be showing more interest in the lodging sector.

As a result, even private companies are raising funds in the public markets, including Sunstone Hotel Properties, Inc., Strategic Hotel Capital, and Eagle Hospitality Properties Trust, which together raised more than $770 million in public offerings in 2004. Other initial public offerings were planned, but postponed (by CNL Hotels and Resorts and Capital Lodging). Public companies have also taken advantage of increased demand for lodging investments as secondary equity issuances topped more than $1.0 billion in 2004. Similarly, the debt capital markets experienced a flurry of activity in 2004, with hotel CMBS issuances raising more than $7.0 billion for hotels (through September 2004), an increase of more than 60 percent relative to the same time period the last year. The Blackstone Group launched itself to the top of 2004's lodging transaction scene, acquiring Extended Stay America, Prime Hospitality Corp., and Boca Resorts, for an aggregate value of more than $5.2 billion, taking these companies out of the public equity market arena to Blackstone's privately held portfolio. Although interest rates are anticipated to increase in 2005, a relatively low rate environment coupled with continued improvement in operating trends should fuel strong activity in the capital markets over the next 12 months.

2. Lodging Fundamentals: How about that! Lodging stocks ahead of the curve.

Continuing improvement in lodging fundamentals continues to provide support to large publicly traded lodging company valuations. In 2004, the majority of the publicly traded lodging companies outperformed the overall market, as the S&P 500 index (as of December 16, 2004) saw a 7.8 percent increase during the year. Comparatively, among the large cap c-corp lodging companies, the average price appreciation was approximately 38 percent, driven by improving RevPAR performance and a favorable supply and demand imbalance that is expected to continue for some time. Even so, the significant price appreciation in the lodging sector far above the market over the past year indicates that additional value enhancement will be somewhat more difficult to accomplish. While most Wall Street analysts continue to view the industry favorably, there is less suggestion of widespread out-performance in the sector in the year ahead.

3. Supply & Demand: Building confidence in lodging supply levels.

Over the past three years, the number of available hotel rooms across the U.S. has grown minimally, helping the pace of the recovery as industry fundamentals slowly turned positive. While changes in lodging demand generally attract more headline attention, it is arguable that the cyclical nature of the industry's supply growth plays a greater role in lodging performance. Changes in lodging supply typically manifest in three-to-five year cycles, driven by the current economic environment, availability of financial resources, and the amount of time needed for new construction to be developed. Supply growth increased 3 percent to 4 percent annually from 1997 through 2000, followed by a sequential slowdown in subsequent years to reach cyclically low levels of 1.3 percent growth in 2003 and an estimated 1.1 percent growth in 2004. Given the severe performance declines in 2001, 2002, and 2003, the financial markets have been strict in terms of funding new projects and development activity remains at historically low levels. With the recovery in lodging demand taking hold in 2004, the dynamics between demand and supply finally shifted as the number of room nights sold increased 4.8 percent, driving occupancy and ADR gains during the year. As the pipeline of new lodging supply for 2005 and 2006 remains in check, further improvement in lodging operating performance should continue during the coming years.

4. New Development: Hotels find favor in mixed company.

As the economics of real estate finance continue to evolve, driven by changing demographics, psychographics and investment preferences, the trend toward hybrid real estate investments is gaining popularity with both developers and owners. For developers, the mixed-use concept offers financing structures often not available to pure play lodging developments. In addition, now more than ever, investors looking for real estate opportunities may consider mixed-use lodging developments that include residential, retail and more significant recreational components such as spa facilities and golf courses. The aging baby boomer generation's desire to spend on vacation real estate has encouraged new timeshare, fractional ownership, and condominium-hotel developments, with lodging operators perceiving high fee growth and brand expansion opportunities in these products both in resort and urban destinations.

5. Condominium-hotel Development: Home Suite Home?

During the past several years, under tight capital availability for new development, condominium-hotels have enjoyed a renaissance, with various condominium-hotel projects currently under construction in South Florida and other central business districts such as Manhattan and Chicago. Often, the appeal to developers is clearer than the appeal to buyers and management companies, with major incentives being an alternative financing structure and a desire to minimize operating risk. Compared to more traditional financing arrangements for hotels that require equity investments between 30 percent and 40 percent (or more) of project cost and long-term debt to be serviced by operations, condominium-hotel debt is largely "outsourced" to individual investor equity or mortgages from unit purchasers. Condominium-hotel units offer owners vacation homes or "pied a terres" with the services and amenities of high-end hotels. When not using their units, owners may opt to place them in a rental program that helps to defray the cost of ownership and may produce a profit.

While condominium-hotels may alleviate some financial risks for the developer, it raises a host of other issues and risks that need to be carefully considered. The fundamentals of analyzing transient lodging demand and the relevant population of residential buyers remain critical to project planning. Further, the importance of properly structuring the way in which various stakeholders' building governance documents, operational budgets, and property management components fit together cannot be overstated. The applicability of securities laws to the offering of condominium-hotel units is the biggest issue affecting the structure and success of this segment and demands careful consideration of the issues and sound legal guidance.

As for the buying decision, the likely premium paid for the availability of hotel services during owner residence and the prospect of operating cash flow from the units must also be balanced by the magnitude of assessment fees and the risk of funding additional operational shortfalls borne by individual unit owners. For the manager, the desire to grow fee income and extend brand coverage must be balanced with the added complexity of developing programs for efficiently managing inventory, dealing with multiple owners, establishing control over common area maintenance and determining responsibility for operating shortfalls.

6. Tourism: Destinations Deliver

In today's competitive environment, where cities as well as other locations are fighting hard for their share of the tourism dollar, the paradigm of "if you build it, they will come" has never been riskier. Today, a location will compete successfully if it is characterized not only by contiguous convention space with nearby hotel rooms, but also by a host of other attributes that tourists, convention attendees and event planners look for. These attributes – such as air and road access, public safety, local transportation, climate, the potential of local industry to boost convention and trade show attendance, monthly patterns of hotel occupancy, average rate and demand segmentation, characteristics of the local and regional population, development projects, dollars allocated to market the location, quality of service, perceptions of cost on the part of visitors and event organizers, the accessibility of shops, restaurants, tourist attractions, cultural institutions and entertainment venues, among others – are crucial to the sustainability of a location as a tourist and convention destination. A holistic approach to strategic planning is required to support success. It is anticipated that this kind of approach will be adopted more and more by cities and other locations in the coming years as competition for out-of-region visitors – those that stay longer and spend more money – becomes more intense.

7. Compliance & Ethics: SOX and 404: No pain, no gain.

Chief Financial Officers continue to experience the challenges of a tightening regulatory environment. With Sarbanes-Oxley Section 404 implementation effective January 1, 2005, public SEC registrants have committed significant resources and dollars to understanding processes and ensuring compliance. As a result, the role of the internal audit continues to evolve, as efforts focus primarily on understanding and evaluating controls for the purpose of improving the reliability of financial reporting and corporate disclosures. As companies become compliant, this, in turn, should serve to improve investor confidence. Although Sarbanes-Oxley governs only those companies registered with the SEC, the push for more process testing will soon evolve into a best practice for all companies, further enhancing financial reporting reliability. Having sufficient resources to dedicate to testing initial and ongoing compliance continues to be a challenge for many companies.

8. Operating Costs: Fundamentals improving, but costs keep rising.

The economic recovery has spurred increases in occupancy and leverage to increase room rates on a national basis. However, maximizing the flow of revenue through to profitability continues to be more challenging, as in particular, rising employee related costs, insurance, and energy costs create pressure on profit margins. While payroll and employee related costs, which comprise the most significant component of hotel operating costs, have increased at a rate slightly higher than that of inflation over the past decade, health insurance costs, which rank second behind Social Security as the largest portion of employee benefit expenses, have skyrocketed since the late 1990s due to increases in prescription drug costs, lack of a preventative treatment culture, and an American population that at once is getting older and less healthy.

Overall, insurance rates have doubled in the past three years as hotels seek coverage against terrorist activity, weather-related events and their resulting business interruptions. The insurance costs of the new security paradigm are only the beginning of costs associated with dealing with such risks; virtually all hotel operators are applying more resources toward on-property security. With four major storms hitting the southeastern region of the United States during 2004's hurricane season, natural disaster coverage, including property damage and business interruption policies, is both more critical and likely more costly in 2005 than ever, a reality that may well be exacerbated in the years ahead by the continued strong focus on resort/lodging development on higher risk shorelines.

In 2004, energy prices were highly volatile, as the conflict in the Middle East pushed energy prices higher, a trend that is likely to continue in 2005. In the 12 months before November 2004, oil and natural gas prices increased 44 percent and 39 percent, respectively, according to the New York Mercantile Exchange. As energy is a major cost component for the hospitality industry- approximately 4 percent of total revenues and 18 percent of cash flows from operations for a full-service hotel, according to Smith Travel Research's 2004 HOST report- operators with fixed price supply contracts were best protected from last year's price increases. This year, we anticipate continued supply uncertainties and high global demand, particularly from a booming Chinese economy and a recovering U.S. economy with a thirst for gasoline and a limited federal impetus for implementing higher Corporate Average Fuel Economy ("CAFE") standards.

On a more positive note, high prices improve the economics for implementing energy efficiency upgrades of lighting, heating, and air conditioning systems. One of the best matches for the lodging industry now is co-generation ("CHP"), with lodging's simultaneous need for both electricity and thermal energy (hot water). In states such as California and New York, CHP can often provide returns of investment upwards of 33 percent. With frequent payback periods of less than one year when taking into account incentives from utility companies or state agencies, property owners and operators exploring such options bear witness to tangible cost savings.

9. Labor Issues: The tug of war continues between fairness and margins.

With UNITE (formerly the Union of Needle trades, Textiles and Industrial Employees) and HERE (Hotel Employees and Restaurant Employees International Union) merging on July 8, 2004, to form UNITE HERE, the combined union, which represents more than 440,000 active members throughout North America, is making a big push to unionize the balance of its industries. UNITE HERE currently represents about 100,000 hotel workers and is pressing to consolidate labor contracts and gain more influence when negotiating compensation, health care benefit contributions, and workloads. Specifically, the union is in the process of trying to align expired (or expiring) contracts in Los Angeles, San Francisco, and Washington, D.C. with contracts in New York, Chicago, Boston, Toronto and Honolulu, which expire in 2006. Without current agreements in place, worker strikes at hotels in San Francisco ensued in the second half of 2004, lasting more than 5 weeks, and further work stoppages could occur in 2005. In addition, the Fair Minimum Wage Act of 2004 was referred to Congress's Subcommittee on Workforce Protections in May 2004. This bill proposed an amendment to the Fair Labor Standards Act of 1938 to increase the minimum hourly wage paid to U.S. workers to $7.00 from $5.15 over three years. While the bill was not passed by the sitting Congress, it could be reintroduced to the 2005 Congress, and a subsequent increase in wages paid to hourly workers could have an impact on hotel's operating margins if improved efficiency does not offset the higher wages.

10. 2005 Outlook: Cautious optimism for corporate travel and hopes that a weak dollar may boost stateside tourism.

With the re-election of President Bush this past November, there remains widespread perception that the Administration will continue to pursue policies highly favorable to business, and Wall Street hopes that the country's economic recovery will continue at a more accelerated pace. However, economic issues remain to be addressed: interest rates are expected to inch higher and possibly slow growth, and a deepening trade deficit is anticipated to place downward pressure on the U.S. dollar.

Within this environment, we anticipate that corporate travel spending will increase moderately in 2005, with resulting increases in lodging demand. With consumer balance sheets and the employment outlook slowly improving, consumer confidence should begin to recover, although the trend in late 2004 has produced less optimism. With anticipated increases in the federal funds rate, the incremental cost of capital for real estate investments could affect transaction activity, although this would seem to be offset by the significant amount of capital focused on investing in real estate in general and the lodging industry in particular. In addition, a higher interest rate environment is more likely to temper the rate of new construction, which is positive for operating fundamentals in the lodging industry. Meanwhile, the benefits from foreign travel to the U.S. encouraged by the weak U.S. dollar have been partially offset by the increased hassle of visa and immigration policies to accommodate such travel to the U.S., as well as a general lowering of the U.S.'s stature among foreign "ally" populations as a result of political policies pursued over the past two years.

Look for the 2005 National Lodging Report, which provides an overview of major developments in key lodging markets across the country, as well as a review of trends impacting the industry in the coming year - coming soon!

The Hospitality Advisory Services Group, a Real Estate Advisory Services practice of Ernst &Young is considered one of the largest and most effective advisory practices in the world. The Hospitality team is focused on delivering value-added solutions that are focused and quick to implement. Industry authorities for over 25 years, the E&Y Hospitality team provides research and analysis of worldwide industry movements and opportunities. Market research and analysis is just one component of its full range of client services. From lodging to tourism, from finance to operations, the industry looks to Ernst &Young to create value in its coordinated delivery of advisory, tax and audit solutions. The hospitality team covers markets in North America, Europe and Asia.

Related Document

Ernst & Young 2004 National Lodging Report

Things look good for the U.S. hospitality industry according to Ernst & Young's 2004 National Lodging Report Update, just released by Ernst & Young's Hospitality Advisory Services practice. The report analyzes the sector's performance in key market segments and cities through the first quarter of this year, and points to key trends likely to affect the hotel industry into 2005. Read the 2004 National Lodging Report (Adobe Acrobat, 665 K) to learn more.
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Nancy Amaral
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