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 Hospitality Industry
Top 10 Thoughts for 2004

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Ten Key Issues for the Coming Year

In recent months, Ernst & Young’s Hospitality Advisory Services practice has conducted its annual review of the lodging industry. The full report, scheduled to be released shortly, found that while the lodging environment of the past two years has been night and day compared to the boom times of the mid to late 90s, the worst of the recent lodging down cycle is likely behind us.

In fact, after one of the most aggressive periods of demand and rate contraction experienced by the lodging industry in several decades, there appears to be a light at the end of the tunnel.

Demand is gradually improving, pricing is stabilizing and the development pipeline is at relative historic lows given the capital markets response to the downturn. These factors bode well for the industry, although it is clear that at the end of 2004, even with improvements underway and upward trends gaining steam, the industry will still have some way to go to achieve full recovery.

While the analysis in our upcoming 2004 lodging industry report goes into far more detail on the past and present condition of the industry and marketplace, a look ahead reveals several key issues we believe will be the primary topics of focus and/or concern for owners, investors, lenders, and operators in the hospitality industry in the coming year.

1.  Public Reporting

The implementation of new and emerging accounting standards may have a deeper impact on the financial reporting of hospitality com-panies in the months to come. While many can debate the notion of what constitutes “interesting times,” most would agree that times are indeed interesting when it comes to financial reporting in the hos-pitality industry. Regulatory activity such as Sarbanes-Oxley and internal changes within the industry itself have had an extraordinary impact. FIN 46 “Consolidation of Variable Interest Entities” will determine what assets, liabilities, revenues and expenses are recorded on an entity’s financial statement. As buy-sell transaction activity increases, FAS 141 “Business Combinations” will determine the amount of purchase price that hotel buyers will record for in-place intangible assets such as franchise and management agreements.  Other newly issued accounting standards such as EITF 01-08 “Determining Whether an Arrangement Contains a Lease” will determine the actual characterization of a hospitality company’s revenues and expenses. Under EITF 01-08, a legal management contract determined to be a lease in substance will result in the management company recording the hotel operating revenues and expenses, instead of management fee income and expense. While the application of these and other newly issued pronouncements will be subject to ongoing interpretation, navigating through these interpretive waters will require a deep understanding of the hospitality industry and business metrics.

2.  Weakening Dollar

As the U.S. dollar continues to weaken compared to most world cur-rencies, there should be an overall positive effect on international travel demand to major U.S. metropolitan destinations. In the past several years the dollar has lost approximately 20% of its value versus the Euro, which now stands at close to $1.30. Any positive effects of a more competitive international travel position, however, could be undermined by additional visa and security restrictions on inbound international travel. Additionally, a weakened dollar has indirect consequences such as increased hotel operating costs and lower overall margins in areas such as energy. Natural gas and oil prices continue to rise during the cold winter season and OPEC appears unlikely to increase oil production over the next several months.

3.  Transaction Activity

Recognizing that the lodging market is in the early stages of recovery, a significant amount of equity has been raised and targeted toward hotel investment under a range of strategic alternatives. As a number of hotel companies, real estate funds and other owners have flooded the market with “for sale” assets, the volume of transactions is expected to increase significantly. Rising interest rates will contribute to this dynamic, as life could be even more difficult for under-per-forming properties, forcing these properties to either refinance quickly to mitigate any anticipated interest rate risk or consider a more aggressive capital strategy including disposition.

4.  Lodging Stocks

After a year in which lodging stocks generally outperformed the S&P 500, opportunities surrounding lodging stocks in 2004 likely will be less obvious. Current stock valuations appear high, although deservedly so. The combination of depressed cash flows, relatively solid profitability, a historically low supply pipeline, and significant inflows into real estate investment funds indicate healthy prospects for industry recovery. Lodging should continue to be an attractive area of investment, given the limited downside through asset values and, in certain instances, the increasingly diversified revenue generated by involvement with related forms of real estate such as timeshare.

5.  Brand Marketing

Will branding become even more important than location as a compet-itive tool? As managing multi-brand lodging portfolios becomes more complex with various brand product standards, marketing initiatives and technology making each brand’s infrastructure more proprietary — it is important for third party owner/operators to improve their knowl-edge of such brand systems to produce the highest value from their franchisee-franchisor relationship. Traditionally, the regional opera-tions of such third-party operators were organized on a geographic basis, in an attempt to reduce travel costs and maximize each regional operations manager’s knowledge of the local market. However, with increasingly sophisticated distribution systems and, in particular with limited service properties, reliance on such systems for a large portion of overall demand and rate yield policies, an increasingly attractive alternative for such third party operators is to realign regional operations by brand versus geography. This organizational approach could potentially ensure that the operator is capitalizing on the power of the brand through a more dedicated understanding and close mon-itoring of brand initiatives.

6.  Management Performance

As lodging development projects become more varied and complex (relating to multiple real estate uses and intricate capital structures), the selection of a management company will continue to become more important. Encouraged by the Tax Act of 1981, significant hotel development occurred in the early 1980s, putting into place many management-friendly deals that were not performance based. Now, with many management deals up for review and more industry attention to realizing operating efficiencies and the sharing of risk among the owners and operators, a formal review of contract terms and alternatives is paramount to achieve financial success. Also, today’s widespread public-private activity often requires a more structured management company selection process. In an environment of more complex, synergistic real estate developments with multiple lodging and residential permutations, experienced management will be necessary to balance the new and challenging service and economic paradigm.

7.  Energy Costs

Because energy is an essential commodity and a major operating cost, energy management will become an even more important area for management focus and innovation. Equipment manufacturers and energy service providers have responded with significant advances in lighting and HVAC systems designed with hotels in mind. In particular, building automation controls, compact fluorescent and LED lighting and laundry water treatment technology have shown promising results in the field. Deregulated electric and gas markets create yet another opportunity to reduce utility costs. Owner/operators with strategic pro-curement programs were able to largely avoid 2003’s market volatility.  As 2004’s energy cost increases show few signs of abating, competitive energy procurement will continue to be a major issue for hotel managers.  Companies who are considering an energy management program that combines competitive procurement with comprehensive demand side energy efficiency measures can expect to realize cost savings of 10% to 25% of their current energy spend. Innovative financing techniques and utility incentives are typically available to assist with implemen-tation costs. Most energy driven projects can be self funded through the savings they create, requiring no up-front capital expenditure.

8.  Employee Benefits

Because of a labor-intensive business model, the hospitality industry is particularly vulnerable to market pressures on benefits, compensation and related human resource program expenses. Many employee benefit program costs continue to escalate at rates of 15 to 20 percent per year – medical, prescription drug and workers compensation costs, in particular.  Other cost pressures for the industry arise from regulatory changes, such as the California Paid Family Leave Act and HIPAA Privacy rules, as well as growing employment-related litigation and an aging popula-tion.  Disability program costs have increased significantly in recent years as the incidence of work place and other injuries have escalated.  Outsourcing, annual benefit plan and cost redesign and growing use of part-time employment are some strategies that help manage these issues. Those companies that develop a strategic approach to cost management in these areas consistently have lower per capita costs than those that operate in reactive and ad-hoc ways as issues arise — critical in a lodging environment that continues to be competitive and challenging.

9.  Mold

Mold is becoming one of the most costly litigation and insurance issues affecting hotel owners, as the plaintiff ’s bar has aggressively pursued an “asbestos-like” strategy to wring settlements out of property owners and insurers. The costs of remediating a serious mold problem can exceed 50% of a hotel’s initial construction cost, not including bodily injury claims asserted by employees and guests that have been exposed to the mold-infested areas of the facility. The scarcity of science proving the medical danger attributed to mold has not fore-stalled aggressive litigation alleging personal injury, a situation that will likely worsen before getting better. Hotel owners will also find property insurers aggressive opponents in mold claims due to policy exclusions for mold related damages. For owners/operators, careful review of mold causation and insurance policy language is critical, because potential property damage claimants may find coverage where none was believed to exist. However, regardless of insurance coverage, hotel owners will likely continue to be burdened with costly remediation efforts that drain investment capital, with negative publicity that stigmatizes hotel properties, and with significant defense costs for lawsuits. 

10.  Tourism

The downturn in the economy over the past few years has contributed to a reduction in tax revenues and increasing city and state deficits.  The public sector is more proactively looking towards tourism to enhance revenues to combat such deficits. Governments recognize the value of visitor spending, which creates both direct and indirect economic and fiscal impact. Cities and states across the country are assessing their current tourism infrastructure and developing strategic marketing/economic plans to create a sustainable tourism market with improved infrastructure, anchor attractions, and both public and private support/investment.

© 2004 Ernst & Young LLP.
All Rights Reserved.

Contact:

ERNST & YOUNG LLP
Real Estate Advisory Services
www.ey.com

MICHAEL FISHBIN 
212.773.4906
NATIONAL DIRECTOR
Hospitality Advisory Services
michael.fishbin@ey.com

CHUCK BEDSOLE 
214.969.0734
Latin America/Dallas
chuck.bedsole@ey.com

GEORGIANNE FSADNI 
212.773.4924
New York
georgianne.fsadni@ey.com

AARON GREENMAN 
617.570.8422
Boston
aaron.greenman@ey.com

TROYJONES 
213.977.3338
Los Angeles
troy.jones@ey.com

DAN LASIK 
703.747.1287
AMERICAS DIRECTOR
Hospitality & Leisure
dan.lasik@ey.com

MARK LUNT 
305.415.1673
Miami
mark.lunt@ey.com

EMILIO PALAZUELOS 
214.969.0787
Dallas
emilio.palazuelos@ey.com

MICHAEL STRANEVA 
602.322.3610
Phoenix
michael.straneva@ey.com

BRIAN TRESS 
212.773.8359
New York
brian.tress@ey.com

Also See: The California 2003 Mid-Year Lodging Report / Ernst & Young / Aug 2003


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