Pramerica Real Estate Investors Hotels: Start of an Extended Recovery? September 2010 Research Paul Fiorilla Vice President U.S. Office Tel 973.734.1501 paul.fiorilla@prudential.com Pramerica Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Tel 973.683.1745 Fax 973.734.1319 Web www.pramericarei.com Executive Summary The hotel sector was perhaps harder hit by the Great Recession than any other segment of commercial real estate, but the trends appear to be favorable over the next few years. Demand for hotels is highly correlated to metrics such as employment and GDP, which are forecast to move in a positive direction over the next few years, albeit slowly. Demand for lodging has been strong in recent months, when national hotel occupancy rates and revenue per available room (RevPAR) have increased sharply. Many hotels are fighting for customers by reducing rates. As a result, room rates have fallen slightly this year, even as occupancy is rising. If occupancy remains strong, operators should be able to raise rates soon. Lower rates principally serve to increase occupancy in the luxury and upscale segments, as travelers can be enticed to pay a little extra to upgrade to a full-service hotel. The limited-service and economy segments have less room to compete in price. Growth in demand is most prominent in group travel, which dropped sharply during 2008 and 2009. Business travel is picking up as corporate profits and business activity picks up. Leisure travel is also growing due to factors including the rebound in employment and household wealth. After a few years of heavy growth, hotel supply has leveled off and should begin to drop quickly. Banks are reluctant to finance new projects of any type, but particularly for hotels. Since it typically takes at least a couple of years to execute a project from start to finish, there will be little new hotel supply in coming years. Investors optimistic about the direction of fundamentals are amassing capital to invest in hotels that far exceeds the amount of product available to buy. That has started to push prices up from their trough, although demand is focused on stable properties in prime locations. Transaction volume remains extremely low, making it difficult to draw firm conclusions. There is a huge amount of distress in hotels, particularly among the sizeable inventory of properties that were financed via CMBS between 2005 and 2007. Nearly 2 of hotel loans in CMBS pools are delinquent. Banks and property owners have been extending many of these loans, but many of these assets will need to be recapitalized within the next few years.
Hotel Demand Looks Good to Grow With an income stream derived from leases that literally change by the day, no sector is as sensitive to swings in the economy as hotels. Historical data shows that hotel demand tracks extremely closely to metrics such as GDP, employment and personal income. In recent history, for example, aggregate hotel demand slipped into negative territory during the recessions in the early 1990s, the early 2000s and the recent Great Recession (Exhibit 1). Meanwhile, demand rose steadily in periods of economic growth, particularly in the late 1990s and 2003 to 2007. Another metric that can be used to predict hotel demand is employment. Through most of the last quarter-century, hotel demand tracked closely to total nonfarm employment (Exhibit 2). Hotel demand dropped by about 8% between its peak in 1Q08 to the beginning of 2010, which reflects the wideranging nature of the downturn. Not only did 8.4 million people lose jobs, but a staggering amount of personal wealth was lost through the decline in home prices and personal net worth, as stock prices dropped. Going forward, GDP and employment are projected to be positive for several years, which bodes well for hotel demand. Moody s Economy.com forecasts that U.S. GDP will rise by 3.6% in 2011 and at a 3.5% annual pace through 2014, while the economy will add 13.7 million jobs Exhibit 1: GDP Growth is Ahead of Hotel Demand Growth Hotel Demand Growth (4Q Moving Average) and Real GDP Growth 6% 4% 2% -2% -4% -6% -8% Demand Growth Real GDP Growth 2Q89 2Q90 2Q91 2Q92 2Q93 2Q94 2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 2Q03 2Q04 2Q05 2Q06 2Q07 2Q08 2Q09 2Q10 Bureau of Economic Analysis, Smith Travel Research Exhibit 2: Hotel Demand Tracks Employment Growth Seas. Adjusted Hotel Demand and Total Nonfarm Employment Index (1Q00 = 100) 110 105 100 95 90 85 80 75 70 65 60 2Q88 2Q89 2Q90 2Q91 2Q92 2Q93 2Q94 2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 2Q03 2Q04 2Q05 2Q06 2Q07 2Q08 2Q09 2Q10 Bureau of Economic Analysis, Smith Travel Research Demand Employment between now and the end of 2014. If the economy performs as expected, or even comes reasonably close, then demand for hotels should grow at a fairly strong pace, especially coming off two years that featured among the most severe drops in demand in the industry s history. 2
Pramerica Real Estate Investors Hotel demand has picked up in recent months in what could signal the beginning of an extended recovery after one of the most severe slumps in industry history. The average occupancy of U.S. hotels rose a strong 4.8% year-to-date through July, while RevPAR grew by 3.3%, according to Smith Travel Research (STR). The numbers are even stronger for the three months ending in July, when STR said occupancy rose by 7% and RevPAR grew by 7.9%. STR s preliminary August 2010 numbers show a 6-8% increase in occupancy and an 8-1 climb in RevPAR. Exhibit 3: Strong Increase in Occupancy Forecast through 2011 Historical and Forecast U.S. Hotel Occupancy and Y/Y Change 68% 66% 64% 62% 6 58% 56% 54% 52% 5 Occupancy (l) Forecast (l) Y/Y Change (r) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Smith Travel Research, Macroeconomic Advisors, PricewaterhouseCoopers 8% 6% 4% 2% -2% -4% -6% -8% -1 Average hotel occupancy is forecast by STR to grow by 6% for the full year in 2010 and another 3.1% in 2011. Even if those predicted increases come to pass, though, average hotel occupancy rates at the end of 2011 would still be 58%, the lowest level since 2003 and about 9% below the 2006 peak of 63.2%. It also would be below the 20-year average of 62%, which means that there is much room for further improvement and that it could be a while before there is a need for more than limited new supply. Exhibit 4: Recent Revenue Growth Derived From Higher Occupancy U.S. Hotel RevPAR Growth by Room Rate and Occupancy 15% 1 5% -5% -1-15% -2 Room Rate Occupancy -25% Jul-88 Jul-89 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Smith Travel Research 3
Group Travel is Rising Hotel demand can be broken down into three broad categories: transient, group and contract. Transient represents booking of fewer than 10 rooms, which accounts for personal travel and a portion of business bookings. Group travel encompasses conferences and large meetings, while contract business involves rooms booked for a month or more. Transient travel encompasses the largest portion of hotel demand. While the proportions vary each month, transient travel regularly accounts for 55-65% of hotel bookings, while group travel typically encompasses about one-third of bookings, according to STR. Contract travel is the most stable, accounting for about 5% of bookings each month. All types of travel fell sharply during the recent recession, but group travel fell much more sharply primarily due to businesses cutting back on travel and the stigma attached to high-end resorts in the wake of the banking crisis. Group travel occupancy rates dropped steeply through most of 2009 on a year-over-year basis, according to STR, while transient travel declined by a much smaller amount. Group travel occupancy rates didn t turn positive until March 2010, but since then each month has produced a solid 1 or more increase over a year ago. Continued strong growth is forecast for group travel as businesses recover from the recession. With corporate profits at record levels and business activity on the rise, corporations are loosening the purse strings to some degree, although they remain more cost-conscious than they were in the 2005-2007 period. Exhibit 5: Demand is Recovering from 2009 Trough Y/Y Change in Transient, Group and Contract Demand 2 Transient 15% Group 1 Contract 5% -5% -1-15% -2-25% Jan-08 Mar-08 May-08 Jul-08 During the recession, Smith Travel Research households tightened belts for many reasons, including job losses, lower total net worth resulting from falling stock and housing prices, reduced consumer confidence, the inability to borrow as banks tightened credit requirements and the desire to save more and reduce debt levels. While those problems have not gone away completely, transient travel is expected to improve steadily. The reasons include pent-up demand from the recession, when some households postponed vacations, and improving consumer confidence. Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 4
Pramerica Real Estate Investors Competitive Pricing In the wake of falling demand and rising supply, hotels have naturally slashed rates in order to bring in customers. The result has been a steep drop in average daily rates (ADR) since the middle of 2008. National average daily rates reached $107.15 in 2008, and then dropped 8.7% in 2009, according to STR. Room rates have continued to move slightly downward in 2010, falling 1.4% to $97.53 through the end of July, according to STR. Competitive pricing has a bigger impact on higherpriced hotels. The ADRs of luxury and upscale hotels fell by 12% in 2009, compared to a 6% drop for midscale and economy properties. Higher-priced hotels have more flexibility to reduce prices, and when the price is reduced, consumers are more likely to choose properties with more amenities. The result is that higher-end hotels are seeing proportionately larger jumps in occupancy even as room rates remain flat. Exhibit 6: Hotel RevPAR Starting to Grow After Sharp Drop RevPAR Growth by Segment (Y/Y) 25% 2 15% 1 5% -5% -1-15% -2 Smith Travel Research Luxury Upscale Midscale 2Q89 2Q90 2Q91 2Q92 2Q93 2Q94 2Q95 2Q96 2Q97 2Q98 2Q99 2Q00 2Q01 2Q02 2Q03 2Q04 2Q05 2Q06 2Q07 2Q08 2Q09 2Q10 Exhibit 7: Room Rates Starting to Grow Again After Steep Decline Seasonally Adjusted Room Rate Growth 8% However, the recent 6% strong demand has 4% started to change the 2% pricing dynamics. The average daily rates of -2% luxury, upper upscale and -4% upscale hotels are down -6% 1-3% through July -8% compared to a year ago, -1 according to STR, but they were higher in the month of July. Luxury Smith Travel Research hotels, for example, posted a robust 6.6% increase in ADR in July over the same month in 2009, rising to $234.18 from $219.91. For full-year 2010, average daily rates are projected to remain flat or slightly down in all segments. As a result, for the full year STR projects RevPAR will rise a robust 8.5% in the luxury segment and 5.4% in upper upscale, with much smaller increases for midscale and economy hotels. Jul-89 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 5
Exhibit 8: Luxury and Upscale Hotels See Uptick in Occupancy U.S. Hotel Occupancy by Segment (4Q Moving Average) $75 $70 $65 $60 $55 $50 Luxury Upper Upscale Upscale All Jul-88 Jul-89 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Smith Travel Research Supply Boom Waning Hotel construction is entering a cyclical low after a brief boom between 2008 and 2010. Historically, the supply cycle comes in booms and busts, as operators rush to build during periods of expansion, while the spigot gets turned off when business is slow. Because it often takes several years between the conception and completion of projects, additional supply often does not respond quickly to changes in demand. Many projects that were started when the sector was performing well were delivered over the past two years, when demand was falling. Consequently, the 3% annual increase in supply in 2008 and 2009 added to the industry s occupancy woes. However, the cycle is changing. Very few new hotels are being built due to the lack of demand and because banks have stopped funding construction of almost all lodging projects. Most banks have large portfolios of underwater construction loans, and are therefore being choosy about financing new projects in all property types. It will be particularly difficult to line up construction financing for hotels, which are considered more risky than traditional property segments such as apartments and offices. Exhibit 9: Hotel Supply About to Hit Dearth Hotel Supply, 1990 to 2014 (forecast) 6% 5% 4% 3% 2% 1% -1% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Property & Portfolio Research 6
Pramerica Real Estate Investors Given that occupancy levels may not return to historical averages for a couple of years, and that it will take banks several years to work out most of their problem loans, the situation is not likely to change for some time. As a result, for the next few years hotel supply is expected to grow at 1% or less per year. Prices Are Rebounding as Sales Activity Thaws Even though current property performance remains weak, the widely-anticipated rebound in the industry has produced a wave of demand for hotels, prompting sales activity to pick up and prices to rise. Sales volume in the first half of 2010 was $3.4 billion (Exhibit 10), while full-year 2009 volume was only $2.5 billion, according to Real Capital Analytics (RCA). It remains a far cry from the $78.6 billion of transactions in 2007, although that year was a major outlier in terms of sales due to merger activity fueled by the CMBS market. RCA s data shows that the average price per key of assets sold was $142,000, up from $97,400 in 2009 and only 5% off the industry peak of $149,500 in 2006. However, volume is far too small to draw firm conclusions about pricing. Most of the limited sales activity involves stable, high-end properties, which skews the average sales price upward in light of low volume. Exhibit 10: Hotel Sales Volume Growing Slowly Annual U.S. Hotel Sales Volume $90 $80 $78.6 $70 $60 $50 $40 $35.5 $28.4 $30 $20 $13.6 $10.8 $10 $1.6 $0.4 $1.1 $2.5 $3.4 $0 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10 Real Capital Analytics Still, the rising average price of closed transactions does point out the plentiful demand for hotels from investors that are willing and able to pay up for better assets. Money chasing hotels comes from a wide range of sources, including REITs, opportunity funds looking to take advantage of distress and foreign investors. REITs in particular have been active, buying more than $1 billion of hotels in the first half. What s more, several new hotel REITs have been formed or are being formed to acquire properties. Different buyers are focusing on different parts of the market. REITs are almost exclusively looking to buy stable properties, using little or no leverage. More opportunistic buyers are focusing on transactions arising from distressed debt, which should be plentiful. As of mid-year 2010, some 19% of hotel loans in CMBS deals were delinquent. What s more, a significant portion of the $111 billion of total hotel sales in 2006 and 2007 were financed with short-term debt that was supposed to be securitized. But banks were unable to shed tens of billions of dollars of debt when the CMBS market shut down that year. Some of that debt has been restructured or liquidated by banks, but a portion remains on banks balance sheet and will be liquidated in the next few years. 7
One factor that could work in favor of the hotel sector is that values fell more sharply than it did in other sectors, and thus has the potential to increase more on the upside. For example, the National Council of Real Estate Investment Fiduciaries (NCREIF) hotel appreciation index fell 36% below the peak it reached at the end of 2007, while the overall index dropped 31.5% from peak to trough. Likewise, the National Association of Real Estate Investment Trust s hotel REIT index fell 84% between its peak in May 2007 and trough in February 2009, while all REITs fell by 68% between the January 2007 peak and the low point in February 2009. Hotel consulting firm HVS Hospitality predicts that hotel values will stabilize in 2010 and 2011 and rise by double-digit levels from 2012 and 2014 (Exhibit 11). Possible Trouble Spots Although the fundamentals of the hotel sector appear to be favorable demand is rising at the same time new supply is waning there are some potential issues on the horizon that would spoil the recovery. Chief among the concerns is the economy. Job creation Exhibit 11: Hotel Price Per Unit Forecast to Rebound U.S. Hotel Price Per Unit, Sales Volume $140 Value Per Room (l) $120 % Change, Y/Y (r) $100 $80 $60 $40 $20 $0 1988 HVS Hospitality 1990 1992 1994 remains slow while second-quarter GDP was revised downward to disappointing levels. If the economy grows slowly for an extended period, the demand recovery will fall short of expectations. And if the economy suffers a double-dip recession, demand will almost surely contract. Another possible trouble spot is the issue of deferred maintenance. Hotels are a capital-intensive property type for owners. During the recession, many hotel operators cut costs to survive. These cutbacks included personnel, capital improvements and maintenance. To keep properties from getting run down, owners of many hotels are likely to have to spend a significant amount of money going forward on maintenance and 1996 1998 Exhibit 12: Public and Private Hotel Markets Rise After Sharp Decline NAREIT, NCREIF Hotel Indexes (Dec. 1993 = 100) 250 200 150 100 50 0 2000 2002 2004 2006 2008 2010 2012 NAREIT Hotel Price Index NCREIF Hotel Appreciation Index 2014 4 3 2 1-1 -2-3 -4 Dec-93 Sep-94 Jun-95 Mar-96 Dec-96 Sep-97 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 National Association of Real Estate Investment Trusts, National Council of Real Estate Investment Fiduciaries 8
Pramerica Real Estate Investors capital projects. That will be painful for many owners that are struggling to raise revenues. In fact, despite the fact that operators have pinched pennies, expenses as a share of total income have slowly risen since 2008, according to the National Council of Real Estate Investment Fiduciaries. Hotels were hit disproportionately hard by the drop in income during the recent recession, not only because they suffered income declines but because their high fixed expenses give them a smaller margin for profit than other property types. By the same token, rising income should disproportionately benefit hotel owners, provided that they keep a lid on expenses that were cut during the hard times. The hotel industry will also have to deal with the fallout from the debt crisis (Exhibit 14). There does appear to be capital ready to step into the shortfall gap between the balance of existing debt and the size of mortgages that properties would qualify for today, but the recapitalization process is likely to be messy and could trigger years of fights between the parties who own the layers of the debt stack. In particular, larger institutionalsize properties have multiple layers of senior and mezzanine lenders who could battle for control of assets if the equity is wiped out. The uncertainty could hinder the performance and upkeep of some properties. Exhibit 13: Hotels Operating Leverage Grew During Downturn Hotel Expenses as Share of Income (Quarterly) 82% 8 78% 76% 74% 72% 7 68% 2Q01 4Q01 2Q02 4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05 2Q06 4Q06 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 National Council of Real Estate Investment Fiduciaries Exhibit 14: Hotel Delinquencies in CMBS Deals Have Skyrocketed CMBS Hotel Delinquencies 2 18% 16% 14% 12% 1 8% 6% 4% 2% Feb-05 Trepp LLC Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 9
Concluding Thoughts After being beaten up during the recession, a number of signs point to positive growth for hotels in the next few years. Hotels are extremely sensitive to the economy, which is in a recovery, even if it is an admittedly tepid one. Both businesses and individuals appear ready to increase travel expenditures, and new supply will be muted for years. Unlike other property sectors whose income is derived from multi-year leases, hotels can immediately take advantage of an improving business environment by raising rates as occupancies recover. Meanwhile, public and private capital is flowing into the sector as investors seek to take advantage of the rebound from the bottom in prices and the expected improvement in property-level fundamentals. Many are betting that because occupancy levels and property values fell during the recent recession by unprecedented amounts, the rebound will be more dramatic than a typical recovery scenario. In fact, in some cases buyers who are paying prices that anticipate a large pop in hotel revenue could be getting ahead of themselves. Even so, hotels should be on the verge of several years of solid performance unless there is an unexpected downturn to the economy or some other shock that impacts the industry. If economic growth falls at the high end of forecasts, the hotel sector could be in for outsized growth in revenue and operating profits. If the economy grows slowly, hotel performance will still be moderately positive. In any event, growth in hotel revenue over the next few years seems inevitable. 10
11 Pramerica Real Estate Investors
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