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Hotels Check In As Hot Real Estate Niche

Investors are piling into U.S. hotels, hoping to cash in on stabilized occupancy and rising room rates amid a climate of cheap debt and depressed supply. It's a mix that has generated profits for the last three years and portends more of the same for the near future.

Through the end of May, hotel buyers and sellers had conducted $8.3 billion in transactions in the U.S., a year-over-year increase of $300 million, according to the Hotels & Hospitality Group of Chicago-based property broker Jones Lang LaSalle (JLL).

JLL also projects that lodging sales will reach $25 billion this year, a 13.6% increase over 2013.

The record-high stock market and rebounding home values have made consumers feel more confident and comfortable about taking vacations, said Arthur Adler, Americas CEO and managing director of JLL's hospitality group. On the business side, the modest economic recovery coupled with slow job growth has necessitated more travel for workers, he added.

More recently, group travelers have begun to book rooms with increasing frequency, which should give the industry a further boost, say Adler and Scott Smith, senior vice president in the Atlanta office of PKF Consulting USA, an advisory and real estate firm specializing in the hospitality industry.

Fundamental Rebound

The important group-bookings segment, which includes state organizations, business meeting groups and worker incentive travel programs, pulled back not only because of the slow recovery, but also as result of the negative reactions to the American International Group's (AIG) widely publicized retreat at a swanky resort soon after receiving bailout funds, Smith said.

Only now is the group travel segment beginning to book rooms on par with its activity before the recession, which should give the industry a further boost, he adds.

"I've been doing this for 25 years and have never seen the kind of economics that are driving hotel revenues right now," said Smith, referring to the steady rise in fundamentals and lagging construction of new rooms. "We think we're in a real sweet spot.

Investors think so, too. The R.W. Baird/STR Hotel Stock Index, which tracks the 15 largest publicly traded hotel companies, is up 11% year-to-date, outpacing the S&P 500 by about five percentage points.

Three of the six largest companies by market cap in IBD's Leisure-Lodging industry group are up by double-digit percentages this year: Marriott International 30%, Intercontinental Hotels Group (IHG) 24% and Hyatt Hotels (H) 23%.

Profits across all hotels rose an average of 10.1% in 2013, the third straight year of double-digit gains, according to PKF Consulting's research affiliate. It predicts that profits will increase more than 10% in 2014 and 2015 as average daily rates, occupancy and revenue per available room (RevPAR) — a gauge of hotel profitability — exceed pre-recession levels.

Hendersonville, Tenn.-based STR, a research firm covering the hotel industry, reported that the average daily rate finished the week of June 14 at $115.61, a year-over-year increase of 4.4%, and that average occupancy increased 2% to 71.6% over the same period in 2013. RevPAR ended the week at $82.82, on average, a 6.5% year-over-year hike.

Occupancy gains supported the bulk of income growth coming out of the recession, but now rising room rates are doing a more lucrative job, said Arthur Adler, Americas CEO and managing director of JLL's hotels and hospitality group.

"Even if you have no occupancy increase, to the extent hotels can increase their room rate, the more of that increase falls to the bottom line," he says.

Pipeline Growing

Experts downplay a rising construction pipeline — at least for the near term. More than 114,300 hotel rooms were under construction at the end of the first quarter, a year-over-year jump of 40%, according to Portsmouth, N.H.-based Lodging Econometrics.

Nearly 293,000 more rooms were in the pipeline, with some 161,700 of them slated to begin construction in the next 12 months, Lodging Econometrics said, although not all are likely to get built.

Developers are adding most rooms in the branded upper- and mid-scale select service segments, the firm reported, which include Marriott International's (MAR) Residence Inn, Hilton Worldwide Holdings' (HLT) Hilton Garden Inn and InterContinental Hotels Group's Holiday Inn Express.

Developers all but shut down new construction as occupancy and daily rates plummeted amid the recession. Historically the supply of new rooms typically grew 2% a year, said Lauro Ferroni, vice president, research and strategic advisory with JLL's hospitality group. But construction has fallen well short of that over the last few years — it was less than 1% in 2013, for example, and this year supply is expected to grow by 1%, he said.

For now, Smith thinks new supply will impact the market around 2018, which should translate into continued investment activity for the foreseeable future.

"Who knows what's going to really happen in 2018 — or tomorrow?" he asks. A drastic change in gas or airfare prices could affect hotel performance, he acknowledged, but the fact that room demand is outstripping supply has reduced investment risk when compared with previous cycles.

Private Equity Leads Way

Through May this year, private equity funds such as RockBridge Capital and KSL Capital Partners completed 33% of the hotel transactions, according to JLL. RLJ Lodging Trust (RLJ), Summit Hotel Properties (INN) and other real estate investment trusts conducted 21% of the deals.

Foreign buyers are also expressing more interest and are expected to plunk down $3 billion for hotels this year, Adler said. High-net-worth individuals and institutional investors such as life insurance companies and pension funds are pursuing lodging properties, too.

In mid-June, however, the Charlottesville, Va.-based financial research firm SNL Financial noted that REITs had shelled out $1.2 billion for hotels in 2014, a year-over-year decrease of 11%.

A slowdown in REIT acquisitions isn't unexpected, Adler said. The companies typically start buying at a downturn's end and then pull back later in the cycle as private equity funds that tap high amounts of debt plow into the market and push up prices.

During the Pebblebrook Hotel Trust's (PEB) first-quarter conference call in late April, for example, company CEO Jon Bortz noted that after pursuing a successful acquisition strategy early in the cycle, the company was happy to "cede" the market to highly leveraged buyers. Plus, he added, fewer quality assets were hitting the market.

The Bethesda, Md.-based owner of upscale hotels and resorts shelled out $376.3 million for 1,083 rooms in five properties over the last 18 months, according to SNL Financial data.

"We've gotten to the point where existing owners look out a couple of years and say, 'Wow, it looks pretty good, why should I be in a hurry to sell if I don't need to?'" Bortz said. "Even in our target markets, we think values are well above what we're willing to pay based on our three- to five-year outlook."