Hotels: Don't Buy Them Now, But Start Looking

While Room Revenues and Occupancies Decline, Industry Sees a Coming Pipeline of Heavily Funded Properties in Need of an Exit

While it might seem paradoxical to talk about hotel acquisitions at this point when the industry is in the tank and sinking, that's just what the major hotel chains are doing. Not only are they talking about it, at least two in the past week have filed registration papers with the Securities & Exchange Commission for plans to raise acquisition money.

Hyatt Hotels Corp. in Chicago filed revised paperwork for a $1.1 billion initial public offering. And while almost all of the money raised will go to selling stockholders and not the company, Hyatt could come up with money for acquisitions if underwriters exercise their option to purchase additional shares.

Also, DiamondRock Hospitality Co. in Bethesda, MD, filed paperwork for a $75 million follow-on stock offering, the proceeds of which could be used to add on to its portfolio of 20 premium hotels and resorts with 9,600 guestrooms.

"Let's not kid ourselves," Gregory Marcus, president and CEO of The Marcus Group, a theater and hotel chain operator based in Milwaukee, told investment analysts at his most recent quarterly conference call. "This is a tough time to be in the lodging business."

Marcus Corp. is experiencing the same problems as the rest of the industry: reduced and falling revenues per available room with the group business segment being the most challenged; and reduced and falling occupancies, particularly at the perceived luxury end of the hotel spectrum.

Still, with that in mind, Marcus added: "We certainly are encouraged by some of the recent economic news that suggests that better times lie ahead. We feel we are starting to gain some traction from the individual business traveler, although the booking window remains very short."

Host Hotels and Resorts Inc. noted similar positive trends in its earnings call this past week.

"While overall demand continues to be weak compared to pre-downturn levels and this weakness is translating into much softer room rates across all segments, we did see several positive trends develop this quarter," said W. Edward Walter, president and CEO of Host Hotels. "Starting with our transient business, for the first time in seven quarters we did not experience a significant decline in transient room nights as the number of room nights sold this quarter matched the prior-year total. Demand in our corporate and special corporate segments fell by just 10% which was the lowest decline in the last five quarters."

What follows are pertinent comments by the CEOs of Host Hotels, Marriott International Inc. and DiamondRock Hospitality during their earnings conference calls this past week about the current and short-term hotel investment market.

Host Hotels Investment Outlook

"On the investment front there are a few signs of [evolving] markets as publicity around real and potential foreclosures continues to grow. As of yet there is little on the market that we find tempting but we continue to monitor activity and we expect to see deal flow improve in 2010 as the combination of lending debt maturities and depressed operating results create more motivated sellers or inadvertent owners," Walter said. "In fact, looking forward through 2014, there is over $30 billion of hotel CMBS debt that is coming due and although difficult to precisely calculate, we think there is over $100 billion of hotel, bank and [life insurance] company debt coming due during that time period."

"Given the reductions in cash flow the industry has experienced and the prevalence of higher initial leverage levels on many of these loans, we would expect we would see additional assets begin to enter the market over the course of next year and into 2011," he continued. "We intend to be opportunistic as market conditions evolve and are optimistic about the future prospects in this arena."

That doesn't mean that Host Hotels would necessarily be acquiring distressed properties, Walter added, saying it is not likely they would be picking up properties with negative cash flow.

"If there was a situation with mismanagement or the opportunity to change brands, something like that, that might create a situation where we would make that type of an acquisition," he said.

Walter said they would be looking at properties that would offer a return somewhere between 11% to 13% on an unleveraged IRR basis.

"I think for us we have typically not bought properties with property specific debt as part of the financing package. We typically have done our acquisitions on an all-cash basis and then figured out the leverage, either using corporate debt or in some cases secured debt," Walter said.

As for pricing, it is hard to discern where property values are right now, Walter added. Effective cap rates on properties that Host Hotels has sold this past year were in the 6% to 6.5% range. Thus, he said, they would be even lower at the higher-end properties where the damage has been greater.

"The other thing I would add by the way is that while it is sort of exciting to talk about distressed acquisitions and everything else, the reality is there will be other properties that will come to market outside of just that environment," Walter said. "You are still going to see some acquisitions and dispositions that are happening in some ways for the same reasons ours were. We were not a distressed seller. We did not need the capital but what we were making is a judgment that in the long run those assets did not belong in our portfolio and we saw a better use for that capital. I think you will also see that happening with other people who are transitioning their business in some fashion and may see a better place to invest capital in which case they are a seller even if they are not under distress."

Marriott Investment Outlook

Arne M. Sorenson, president and chief operating officer of Marriott International, said the hotelier started to experience improved occupancy in the third quarter. However, new hotel supply expected in 2010 will still provide headwinds against near-term improvement in business fundamentals, especially in the upscale segment.

Sorenson said Marriott is monitoring when and how investment transaction volume will start to step up.

"It has not been significant to date. There are obviously a significant number of hotels out there of all varieties that have debt loads which put some pressure on their structure," Sorenson said. "In the world we're in and in which banks are still wrestling with their balance sheet and also thinking about whether or not this is the right time to try and sell an asset, right now they're probably generally kicking the can down the street and not forcing transactions to happen."

"I think as we get closer to maturity of debt or we get closer towards an environment in which there are buyers out there with pricing that seems to make sense, we could well see transaction volume step up," she added.

"There is a lot of equity out there ready to do these deals, a lot of our good partners are out there ready to do these deals," Sorenson said. "Our druthers, of course, would be to do the deals with our partners and take management or franchise contracts along the lines of our model, but still participate actively in converting hotels to our system. And we could also look at doing some of those deals on our own. If we did, it would be based on valuations and I have a strong confidence that we would be able to turn around and sell those assets in the relatively near term and retain the management contracts going forward."

DiamondRock Hospitality Investment Outlook

Mark Brugger, CEO of DiamondRock, said his company is looking forward to the coming acquisition environment.

"The lethal combination of dramatic declines in hotel cash flows and the use of excessive leverage during the last peak will inevitably lead to good acquisition opportunities," Brugger said. "Just looking at hotel CMBS debt alone, nearly $30 billion of hotel CMBS debt is maturing through 2012 and about $8 billion in total is already unable to meet debt service. The open question remains, just when will these opportunities ripen?"

Brugger said it’s too early to call it a buyer's market just yet.

"Obviously people are trying to call the time," he said. "I think some of it is just world perspective how optimistic people are about the future deals versus what they may have in hand today. We are not seeing a tremendous volume of deals coming through our doors at the moment."

Of the deals coming through the door, they are "coming in two flavors," he said.

"First," Brugger said, "are hotels with negative operating cash flow where the banks are kind of forced to take them. And you will see those more in the hardest hit markets like Hawaii and San Francisco. Some of those deals are difficult to deal with a public company with a negative cash flow, unless there are really compelling valuations. So we will see some more of those deals and we’ve seen those increase in volume over the last couple months."

"The second type of deals that we are starting to see are the ones in markets that haven’t fallen this far, markets like Washington, D.C., where there still might be some equity left with some of the private equity players, but they have a loan that matures in the next year or two," Brugger added. "Those are probably more interesting for the public companies like us as early deals."

By Mark Heschmeyer
October 21, 2009