After a bumpy few years, investors are returning to the US hotel sector as profits and occupation levels rise. An article from RICS Business featuring Tim Smith from HLL Humberts Leisure's Hotel team.

Source/Contact: RICS Business

Sean Hennessey explains the resurgence in the US market.

Hotels are back. After struggling with the economic slowdown and the fear of travel that has affected many markets over the last few years, the fundamentals of the hotels business have improved in most markets around the world. This upturn has not gone unnoticed by the US investment community, where hotel transaction activity has been robust.

The three main basics in real estate investment are utilisation, rent and profitability. For hotels, these translate into occupancy, average daily room rate and gross operating profit.

Hoteliers know that rooms are highly perishable: one night's vacancy cannot be recouped at a later date. To maximise occupancy, hotel managers have tried to take a page from the airlines' practices of yield management and consumer incentives, which are designed to maximise occupancy. However, the industry as a whole seems to have been stuck in a 60-65% occupancy range for some time. Why has it not grown higher?

One notable factor is that hoteliers have emphasised the development of limited-service brands, which are designed to run more efficiently than full-service hotels. As limited-service hotels comprise a greater proportion of the hotel inventory, and remain economically viable at lower occupancy levels, there has been a dramatic decrease in the hotel industry's break-even level.

The industry also has a fairly low rate of hotels being taken out of use. Some wags joke that the hotel business in the US is not over-built, but under-demolished. Hotel brands focused on maximising market share often build hotels to oust weaker competitors rather than to meet local demand.

The bottom line

Savvy hoteliers know that it is more profitable to sell one room at $500 than to sell five rooms at $100, as housekeeping and other costs are much lower. Therefore, the emphasis for many operators has shifted to maximising room rates instead of building occupancy. Room rates are rising again, after falling in many markets during 2002 and 2003, with many markets expecting two or three years of double-digit growth. Many hotels now have room rates back to pre-9/11 peaks, although only in nominal dollar terms.

As hotels fill closer to their capacity, and as room rates experience real growth, most analysts expect dynamic profit growth in the US hotels sector. The higher a business's 'operating leverage' (ie. the percentage of fixed costs in its cost structure) the more its income is affected by fluctuations in sales volume. As the hotel business has a high operating leverage, many investors are expecting profit margins to expand strongly as the recovery continues. For example, while a typical hotel might have a net income ratio of 25% of total revenue, the marginal profitability of each additional dollar of revenue can be as high as 70 cents.

‘Hotel brands focused on maximising market share often build hotels to oust weaker competitors rather than meet local demand’

However, there are some problems that could noticeably dampen the expansion, though not completely offset any profits. One is 'amenity creep', or the urge to add more expensive amenities and services to a hotel operation as revenues expand - upgraded toiletries, more fresh flowers, more guest service staff, etc. Another is upward pressure on operating costs from rising labour, insurance and energy prices. Finally, many hoteliers need to catch up on maintenance and capital upgrades that were deferred during the cyclical lull. Despite these minor problems, the promise of strong cyclical performance is driving

Investors from opportunity, hedge and pension funds towards the hotel industry in a big way. Furthermore, low yields in other core investments such as office, retail and industrial property are making hotels look attractive in comparison. This institutional interest should remain strong for two to three more years, and then moderate as the profitability cycle approaches maturity.

...and what's happening in the UK?

Tim Smith of HLL Humberts Leisure summarises the UK hotels market:

There have been a significant number of transactions in the UK market in the past few years. These have revived interest in the market and attracted new investors, thereby increasing the available funds for hotel investments - very much mirroring the US market upturn that Sean Hennessey describes.

One of the reasons for this increased interest is the maturing of the hotel market Property investors are now really starting to understand the risk-reward profile of the various hotel operating agreements and are no longer frightened by management contracts.

Furthermore, they are comparing investments in other sectors with the potential returns from leisure investments and realising that there is currently a significant difference.

However, the hotel market has assisted in this process by the influx of brands and the importance, from an operating perspective, of operating under a corporate flag. The market is now brand driven, and there is no sign of this changing. Indeed, further brands are evolving and being launched in the UK each year. This increase in the number of brands - and therefore possible occupiers for each site - has increased demand for the sites. Although value is intrinsically linked to the potential business that can be generatedfrom the completed hotel, and more particularly rates and occupancy levels, a dramatic rise in site values has not been seen.

With regard to the operational business, the surveys undertaken by the various consultancies have indicated that London recovered remarkably quickly from the bombings of 7 July 2005. Occupancy was back to pre-bombing levels within 6 to 8 weeks. However, when talking to the operators, there is a more guarded response. That being said, it is difficult to find a hotel room in central London for under £100 per night

The outlook for the UK market is certainly good, if not quite 'great: The UK, and London in particular, generally remains a must-see destination. The improving transport links to and around London should ensure a continued positive outlook. Providing that media interest and the profile of 'UK plc' remains high, the hotel industry should prosper.

There are good opportunities currently for experienced hotel property specialists. However, both operators and investors are becoming more and more sophisticated. Therefore, the level of knowledge required to provide best advice is constantly increasing. A detailed knowledge of the market is required to ensure opportunities are purchased at the correct price. There are plenty of opportunities available, but purchasing at a sensible price is crucial.

Occupancy levels remain strong, particularly in London, and average room rates are improving. As the specification of hotels improves so does the ability to increase room rates. Providing there is not a substantial increase in legislation and government interference, operating profit should not be dramatically affected in the short to medium term. However the costs of complying with new legislation, such as the new licencing laws and the Disability Discrimination Act, can be substantial.

At nature's mercy

Of course, the hotel industry is known for its volatility, which has been highlighted by recent world events. For example, terrorist threats, the 2004 Indian Ocean tsunami and outbreaks of SARS, foot-and-mouth disease and BSE have affected the markets in various countries, and last year the US and Mexico had an exceptionally active hurricane season, which devastated cities such as New Orleans. More than two-thirds of the city's hotels were closed and one of the country's top convention centres was put out of commission for months. Considering that efforts were still very much under way to repair damage in Florida from the previous year's hurricanes, the impact of the 2005 storms could last for the rest of the decade and beyond.

The short-term outlook following the 2005 hurricane season is for increased demand as the recovery and rebuilding work generates higher demand from construction workers. Experts are divided over the longer-term implications, but whatever effects Katrina and other hurricanes have on the US economy as a whole, the hotel sector's health will be affected accordingly.

One notable immediate impact has been a rise in the cost of construction materials and the lead time for their delivery, along with a consequent decline in new hotel starts. With so much of the US construction industry's resources dedicated to rebuilding hurricane-affected areas, there is little spare capacity for other real estate projects; and the cost issue will be a problem for the next few years.

Declining hotel construction, and thus limited competition, will enhance the profit picture for existing US hotels, assuming that the economy remains healthy, particularly as hotels are already focused on raising room rates.

In summary, the US hotel industry has entered a strong growth phase that is drawing a great deal of interest from groups who, in the past, have shunned the sector for investment How long will the good times roll? According to Smith Travel Research, the industry is well into a recovery in operating fundamentals. Investors have their fingers on the pulse, and many of the bargains have already been snapped up. However, there is no reason to believe that sound opportunities are no longer available. Of course, the industry is subject to larger economic forces, but hotel lodging fundamentals suggest that the industry has a fair amount of cushion to absorb such shocks. Right now the future remains bright.

Top 10 US Hotels

The largest hotels in the US by number of rooms are all in Las Vegas:

1. MGM Grand 5034 rooms
2. Luxor 4408 rooms
3. Excalibur 4008
4. Circus Circus 3770 rooms
5. Flamingo 3642 rooms
6. Mandalay Bay 3309 rooms
7. Bellagio 3270 rooms
8. Las Vegas Hilton 3174 rooms
9. The Mirage 3044 rooms
10. The Venetian 3036 rooms

Source: www.govegas.com

Sean Hennessey is founder and chief executive of Lodging Investment Advisors, which advises lodging lenders and investors throughout the world. Tim Smith BSc(Hons) MRICS is a specialist chartered surveyor on the HLL Humberts Leisure Hotels team.

Contact: Tim Smith BSc MRICS