Life Near the Peak

By Scott Smith, MAI

During the dark days of 2002, who other than the savviest of the hotel experts at PKF Hospitality Research and PKF Consulting could have imagined that the U.S. hotel industry would ever recover? As we approach the second half of 2006, let's look back at what has happened. Growth of the U.S. economy restored the ability of firms and households to travel and the efforts by Transportation Security Administration, as well as the passage of time, restored the security of travel. Many city hotel markets are almost fully recovered in occupancy and some, such as New York and Washington D.C., are experiencing strong and profit-rich ADR growth. As the data from the 2006 Hospitality Investment Survey show, hotel capitalization rates reached a historic low. Even with values at such high multiples to income, keeping track of hotel transactions has become a full time job.

So will things always be this good? Clearly not! 'Life near the peak' quickly becomes 'life at the peak' - an exhilarating, but inherently treacherous tenure. Enough historical data now exist to build a convincing argument that hotel markets are cyclical, and thus, the U. S. hotel market will come down from this peak. The questions are when and how much. We have plenty of experience to answer the 'how' question. Consider three possible scenarios:

1. Depending on the severity, a recession pulls the hotel market down the mountain either quickly or gradually.
2. Another (heaven forbid) catastrophic event occurs. Bird flu remains a worry for the immediate future.
3. A supply (i.e., new hotel construction) avalanche whisks the hotel market off the peak.

Most of the major U.S. hotel markets seem to be flourishing near the peak. Combining data from Smith Travel Research (STR) with able assistance from Torto Wheaton Research (TWR), PKF Hospitality Research (PKF-HR) continually monitors historical performance of hotels in 52 of the largest U.S. markets (we lost New Orleans for a while). For these cities taken together, impressive increases in occupancy and ADRs were recorded in 2005. Occupancy for all hotels climbed from a 52-city average of 65.0% in 2004 to 67.6% in 2005. Room rate increases usually follow close behind occupancy as occupancy rates move closer to long-run averages, and it appears no different during this cyclical upturn! The average ADR improved from $97.90 in 2004 to $105.69 in 2005. This 7.9% increase far exceeds the general rate of inflation for the period. Too many cities to mention experienced double-digit growth of RevPAR in 2005. So what are the 'few' exceptions where it's not all good? Some cities, such as Albany, Hartford, Indianapolis, and Trenton only registered RevPAR gains at or near the rate of inflation, but at least there were increases! A full report on performance in these cities may be found in Quarterly Trends in the Hotel Industry - United States at www.pkfc.com/store.

The 2006 edition of Hospitality Investment Survey (now available at www.pkfc.com/store) reflects cautious optimism of both debt and equity capital providers. With overall capitalization rates and discount rates at historic lows for this survey (which began in 1988), property value increases may not have much fuel left from the capital markets. Yet, cash flow growth keeps investors optimistic. Investment markets tend to lead the market for rooms so some price-shocked investors may be experiencing early symptoms of peak-related altitude sickness.

Survey Results

The results of Hospitality Investment Survey conducted during early 2006 bear out the observations in the previous paragraphs. The average capitalization rate for hotels of 8.9 percent stands at an all-time low since this survey began. The 2006 rate is more than 80 bps below the rate found in the 2005 survey. Discount rates, or un-leveraged IRRs, for hotels declined to 13.3%. Consequently, the historically large spread between the overall capitalization rate and the discount rate now equals about 4.4 percent, and suggests owner expectations for growth in net operating income will continue beyond the expected rate of inflation. Despite fears of rising interest rates and Federal Reserve actions, the cost of financing continued to fall, thereby decreasing investor's rate of return requirements as compared to 2005. Loan-to-value ratios slipped back to below 70 percent, but remain above levels recorded in several prior periods. These terms indicate that lenders feel adequately protected from a reoccurrence of delinquency and default risk experienced in 2002 and 2003.

This edition of the PKF Hospitality Investment Survey also reveals how lenders currently offer mortgages to equity investors for these two property types. Differences in default risk between full-service and limited-service hotel lending arise through higher interest rates (an average of about 35 bps.). Somewhat surprisingly, longer loan terms can be obtained for limited-service mortgages. Other loan terms are nearly identical for the two business types and all terms appear quite favorable to borrowers by historical standards.

To purchase a copy of the 2006 Hospitality Investment Survey, please visit our website at www.pkfc.com/store.

Scott Smith, MAI, is a Vice President in the Atlanta office of PKF Consulting. Phone: (404) 842-1150 ext. 233. Email: scott.smith@pkfc.com