by Lesia Bates Moss and Margaret Holloway
Of all the commercial real estate sectors, the tragic events of 2001 took the biggest toll on the lodging industry. Reduced business travel due to a weakening economy had already adversely affected lodging industry performance—and then September 11 happened. The resulting air travel fears, delays and disruptions sent RevPAR (revenue per available room) into a dramatic decline in the weeks following the attacks. During the week of September 16, Houston was the only U.S. city that posted a RevPAR decline of less than 20 percent. Meanwhile, four cities (Boston, Chicago, New Orleans and Orlando) had RevPAR declines in excess of 60 percent, according to Smith Travel Research. However, there appears to be light at the end of the potentially long tunnel as RevPAR has continued to improve after the initial declines.
| Lodging Sector |
| # of REITs | 15 |
| Market Cap. | $7,260,410* |
| Industry Market Cap. | $154,898,617* |
| % of Industry | 4.7% |
| Average Dividend Yield | 9.5% |
| YTD Total Return | -8.1% |
| 1-year Total Return | -8.1% |
| 3-year Total Return | 8.8% |
| 5-year Total Return | 3.3% |
| Weighted Daily Volume (shares) | 609,160,838 |
| Weighted FFO Growth (2001–2002) | -9.4% |
*These figures represented in thousands. Data as of Dec. 31, 2001.
Source: NAREIT |
Although the worst has likely occurred, the outlook for the lodging sector continues to be negative based on the expectation that the lodging industry will remain under pressure well into 2002. Hotel property owners, including lodging REITs, are particularly vulnerable, and will be more adversely affected than those companies whose revenues are generated primarily from management and franchise fees. Lodging companies generate cash flow from owned properties, and a sharp decline in average daily rates or occupancy have an immediate impact on hotel profitability. The daily lease structure and high operating leverage that cause earnings to drop by a multiple greater than the decline in revenues contribute to wide swings in performance.
The ailing economy and the September 11 attacks created particular challenges for the lodging industry, making it difficult to predict the depth and extent of the sector’s deterioration—particularly in light of unusually strong 2000 RevPAR benchmarks. Due to lingering flying fears and the ongoing threat of another attack, demand generators such as tourism and business travel may not return to past levels to contribute to material performance improvement in 2002. There is also concern that lodging REITs’ financing choices could become constrained, although a number of firms, including FelCor Lodging Trust Incorporated, Host Marriott Corporation and MeriStar Hospitality Corporation, successfully completed bond offerings during the fourth quarter of 2001.
Moody’s Investors Service has reviewed and/or taken ratings action on most of its rated lodging REITs. The outlooks for most of the ratings are negative. These rating actions reflect the increasing business and financial risks, and significant deterioration in many firms’ credit profiles in the aftermath of September 11. Not all lodging REITs are being equally affected by these stresses. For instance, Hospitality Properties Trust’s ratings were affirmed, with a stable outlook, based upon the firm’s strong balance sheet, well-laddered maturities and conservative lease structure that should provide adequate cushion in stressful operating conditions.
Improvement Begun, Rebound Will Be Slow
The week following September 11 represented the low point for the lodging sector. While the lodging industry is not out of the woods yet, RevPAR has been improving. Airline traffic has started to increase and lodging companies are reporting fewer cancellations of hotel bookings. However, the amount of travel is expected to remain below 2000 levels in the near term. Moody’s expects leisure and business travel to rebound, but the question is when and to what level? Leisure travelers may opt for drive-to locations over flying, which should help some locations while continuing to constrain destinations that rely on air travel. Corporate travel is likely to rebound more slowly as the sluggish economy has forced many companies to reduce travel budgets and staff.
The good news is that hotel owners face this down market cycle with low levels of new hotel supply, which will help reduce the effects of weak demand on hotel occupancy and rates. In addition, most lodging companies have initiated cost reductions, including capital expenditures and marketing, intended to soften the blow to the bottom line. Some hotels have gone so far as to cut back on services, temporarily shutting down floors, reducing hours of operation or shutting down restaurants. Staff cutbacks appear to be the most prevalent cost reduction measure.
However, there is concern that cost reduction efforts may not be sufficient to reduce margin erosion given REITs’ business model and high dividend payouts. Some lodging companies have little cushion available for further deterioration in their credit measures, reflecting high debt levels. As a result, some firms are expected to pursue asset sales and/or further restructure operations to improve their liquidity profile.
Recovery Will Vary by Segment and Location
The recovery in hotel performance will vary by hotel segment, location and demand profile. In general, most of the lodging companies have experienced some deterioration in their credit profiles. Highly leveraged firms, and those with significant exposure to upscale and luxury hotels, such as Host Marriott and MeriStar Hospitality, will face the most significant challenges.
The upscale, full-service, luxury segments have been the hardest hit, as these segments rely heavily on corporate and group travel. Many of these hotel properties are located in gateway cities such as New York, Chicago, Atlanta, Boston and San Francisco. Even if conventions are not cancelled, there may be fewer guests showing up than in previous years, resulting in weakened occupancy. In addition, the rebound for these segments could be prolonged given material levels of supply.
High-profile leisure destinations where the majority of guests arrive by air, such as Hawaii, have and will likely continue to experience a substantial decline in demand.
In contrast, drive-to destinations near major population centers should hold up relatively well. Limited service, economy and budget properties are generally located in drive-to markets, and have been the least impacted as travelers trade down to less expensive brands. These hotel segments also benefit from relatively low levels of new supply. Equity Inns, Inc. and Winston Hotels Inc. are examples of firms in these segments.
Diversification and Financial Flexibility Are Key
Going forward, earnings of lodging firms will likely be more volatile as consumers absorb the new realities of increased travel risks. Many firms have quickly responded to this change in consumer demand by implementing cost reduction measures and refinancing short-term, variable-rate debt with long-term fixed-rate debt. Others have successfully re-negotiated their bank credit facilities.
The events of September 11 have added uncertainty around future performance. It is difficult to tell when and if demand will ever return to historic levels. Nonetheless, these events have demonstrated the importance of diversification as companies with less exposure to fly-in markets have rebounded more quickly. In addition, hotel managers and franchisers have experienced a smaller decline in earnings because they are less sensitive to operating leverage.
Diversification, the quality and location of properties, brand equity and customer mix will become even more important differentiators of lodging REITs’ credit quality during the current shake-out. However, these important qualitative factors cannot outweigh weak financial measures—particularly with the backdrop of an ailing economy. Financial flexibility, including ample levels of unencumbered properties, manageable debt maturities and bank line capacity, and low debt levels will help temper the negative effects during economic downturns.
Lesia Bates Moss is vice president of Real Estate Finance for Moody’s Investors Service and Margaret Holloway is vice president of Moody’s Lodging and Gaming group.
