Strategies ranging from altered capital structures to new takes on the lease arrangement can position hotel owners to take advantage of a changed economy.

A new economy with a different set of rules is upon us. Beginning in late 1995, the typical pattern of the post-World War II cyclical economy broke down and was replaced by what could most aptly be termed a “perpetual motion economy.”  

Looked at more closely, the perpetual motion economy works like this: 

1. A rising stock market generates wealth.
2. Spending creates jobs and higher wages, motivating companies to expand production and flood the market with new supply.
3. Jobs and higher wages generate confidence.
4. Confidence encourages people to invest in stocks and spend (the wealth effect).
5. The stock market rises even more--and the wheels keep turning.

Impact on the Hotel Industry

The effects on the hotel industry will be wide ranging. Given the growth in on-line hotel reservations, many hotels are now finding that they cannot easily raise room rates. Moreover, the last two years have witnessed a significant increase in supply in principal markets, with approximately 160,000 new rooms coming on line in 1999. 

This has imposed additional pressure on hotel owners to think twice before raising room rates and causing a dilution of demand. Weak RevPAR growth (0.4% in 1999) can further magnify the damage, as collateral collapses in value and impacts the debt burden that hotel owners or developers assumed to buy the hotels in the first place. Owners who borrowed excessively could face even more problems, particularly if excess supply or turmoil overseas triggers any weakening in demand that would further erode room rates.

The net result is that investors may seek to pull out of or decline to enter businesses with high labor and capital costs, such as hotels, which become more burdensome if there is pressure to reduce prices. In 1999, labor costs accounted for approximately 30% of total revenues, while capital costs (interest payments) averaged close to 11%. 

Current investors and prospective investors may also may find that, especially with the recent rise in interest rates, hotels have fallen out favor with investors and lending has become even more constrained. Construction deals with lesser debt will diminish equity returns to investors who generally seek a 20%-25% return. With low-leveraged deals, the returns will not be near such levels. In addition, the prices of more hotel assets are fully discounted for earnings that have eroded due to overbuilding.

Finding Ways to Profit

Even with these pressures, there are ways for hotels to adjust to the new economy. They include:

• Strategic alliances and investments with “real estate dot.coms,” as well as e-business suppliers. These moves can make hotels more attractive to investors who have ridden the market up with Internet companies.

• Mezzanine financing. This credit structure offers more pre-payment and financing flexibility than equity, and any expected upside expected in terms of both performance and the owner retains capital appreciation of the hotel.

• Acquisition of a franchise/management company. Such companies offer both stability and growth potential from fee income, have little or no real estate exposure, usually have strong balance shots and enjoy significant free cash flow.

• Synthetic leases. A synthetic lease allows an entity to build or acquire real estate without negatively affecting its balance sheet or operating ratios. 

• Credit tenant leases (CLT). The CLT can be used to monetize existing properties. That is important since synthetic leases are unavailable for companies with existing assets and normal sale/leaseback arrangements are uneconomical because the cost of financing is usually higher than the tenant’s marginal cost of capital.

• Sale/leaseback. The benefits for the selling company would be: Extra funds provided for expansion and a longer time than is possible from other sources; released funds which can be invested elsewhere at a higher return; tax advantages, via the deduction of rental payments, that can boost earnings and the ability to pay down debt to improve the selling company’s credit rating and attain a lower cost of capital. Sale/leaseback financing can be used on both existing and undeveloped hotels.