By Tara Innes and Patricia Wright

The last several years for the lodging sector, particularly since Sept. 11, 2001, can best be characterized as turbulent. Demand for lodging, particularly by the business traveler, has suffered the fallout of weak economic conditions, geopolitical instability and terrorism concerns.

On the whole, 2003 marked the third consecutive year of industry RevPAR (revenue per available room) and ADR (average daily room rate) declines, offset only by resilience of the leisure travel segment, which kept occupancy levels propped up. Though widely slated as a turnaround year, positive economic momentum that emerged leading up to 2003 was reversed by the war in Iraq and outbreak of SARS during the first half of the year.

Trends through the second half of 2003 were more encouraging, as geopolitical and health concerns abated. Lodging demand showed its first signs of life as positive economic data, continued strength in leisure travel, healthier corporate travel activity, and an improved corporate profit outlook translated to a 2 percent RevPAR gain, versus the 4 percent decline in the first half of the year. However, full-year totals still reflected a 1 percent decline. Industry estimates now call for a 4.5 percent increase in lodging demand in 2004 and 2.3 percent increase in 2005. Supply growth is expected to continue to run at a modest 1.4 percent in 2004, and 1.6 percent in 2005, driven by mid-scale chains.

Recovered or Recovering?

Evidence of improving demand fundamentals, combined with a moderating supply outlook underpins Fitch’s current view that the lodging industry is in the early stages of recovery. This view is reflected in outlook revisions taken in December 2003, in which Fitch raised the outlook of Starwood Hotels & Resorts (NYSE: HOT) and La Quinta Properties, Inc. (NYSE: LQI) credits from negative to stable. The change reflects the view that these companies are well positioned within their rating categories to absorb any further unforeseen weakness in travel patterns.

Further support for the stable outlook is provided by the efforts of a number of REITs and C-corps such as Starwood Hotels & Resorts, Host Marriott Corporation (NYSE: HMT), MeriStar Hospitality Corporation (NYSE: MHX) and FelCor Lodging Trust Incorporated (NYSE: FCH) who are using the proceeds from common equity issuance and/or asset sales to fund debt reduction thereby beginning the process of restoring balance sheets to pre-recession levels. These efforts are viewed positively. Asset- laden companies with exposure to major urban markets and business travelers should generally thrive in an upswing. And, barring another external shock, most lodging companies should also benefit from easier comparisons in the first half of 2004 given the negative environment created by external shocks in 2003.

Nonetheless, decreeing that the sector is in the throes of a full-blown recovery would be premature. To date, the recovery has been occupancy-led, which on its own will not solve the problem. First, greater pricing power—eroded in recent years by the retrenchment of corporate travel, shorter booking windows, and pricing transparency (due to the proliferation of information on the Internet)—will be a material component of a sustained recovery. Meaningful earnings before interest, taxes, depreciation and amortization (EBITDA) increases will be derived through ADR gains, which flow through to the bottom line at a higher rate than occupancy.

Second, effective expense management will also be a key component of recovery in 2004. Rising costs, including labor, insurance premiums and taxes took a toll on results in 2002 and 2003 and have the potential to offset ADR-driven margin enhancement in 2004.

Looking forward, margin expansion and the ability for hotel companies to manage anticipated increases in revenues through to the bottom line, enhancing capital formation will be a key determinant of credit improvement in 2004 and 2005. Factors that could lead to improvement in lodging ratings rest on the sustainability of demand recovering, improvement in the firms’ liquidity and credit profiles.

Behind the Numbers

Fitch believes pricing power and ADR gains in 2004 will be largely driven by expanded corporate travel budgets. As the economy recovers, and companies return to normal commerce and business activity, companies generally return to healthy spending levels. As the industry’s highest ADR customer and the segment that fell the farthest in the downturn, the most meaningful ADR gains will derive from a rebound in the business traveler segment.

Pricing transparency, on the other hand, represents a more systemic challenge to pricing power, and will likely continue to complicate yield management over the near term. The Internet has greatly reduced the asymmetry of pricing information between hotels and consumers, and greatly reduced the time involved to obtain this information. Lodging companies are currently investing significant time and effort to regain pricing integrity and reduce commission rates to third-party Web sites. Marriott’s “Look No Further Best Rate Guarantee” launched in January is a good example of these efforts. But strategies such as these are relatively new, the exception rather than the norm, and will likely take some time to take effect.

Challenges to earnings gains and cash flow improvements remain. In response to declining revenues, lodging companies temporarily eliminated certain services and significantly reduced others in an effort to minimize costs. Health club facilities were closed or their hours curtailed, food and beverage offerings were reduced and in some cases restaurants were shuttered. Frequently, concierge, laundry and other services were eliminated altogether.

With increased transparency of room rates, available services will likely influence business travel decisions about where to stay in the coming months. The need to ramp up services to capture and maintain share could stunt earnings and margin improvement. Earnings improvements are needed to grow capital to warrant upgrades to pre-recession rating levels. The ability of hotel companies to meet their debt service requirements, as measured by the ratio of earnings to interest expense (EBITDA/interest) have declined significantly from 2.4x at year-end 2000 to 2.0x at year-end 2002. The ratio of earnings-to-interest plus preferred dividends, another measure of a company’s ability to repay its debts, also declined from 2.3x to 1.8x over the same period. Within the hotel company universe, REITs led the way with the largest declines of 2.2x to 1.3x, on average. Though not all of the companies have reported, little improvement has been evident in year-end 2003 results.

Further, cash flow pressures for lodging REITs have been particularly acute. The unprecedented occupancy and room rate declines that followed the events of Sept. 11 combined with the economic downturn to reduce lodging company recurring earnings by 40 percent on average during the two years from year-end 2000 to year-end 2002.

Lodging & Resorts
# of REITs	14
Market Cap. (in thousands)	9,891,828
Industry Market Cap. (in thousands)	245,213,865
% of industry	4.0%
Yield	2.7%
YTD Total Return	1.8%
One-Year Return	66.9%
Three-Year Return	16.1%
Five-Year Return	52.3%
Average Monthly Trading Volume (shares)	5,540,460
Source: NAREIT. Data as of Feb. 27, 2004

The REIT Result

Lodging REITs found themselves repeatedly negotiating with their bank lenders to avoid financial covenant defaults, primarily interest and cash flow coverage requirements. Unlike other sectors, which benefited from refinancing debt in a low interest rate environment, interest rate declines for lodging companies were often offset by the increased cost of borrowing as credit ratings deteriorated moving several companies below investment grade.

The REITs, which are generally positioned among lodging companies as hotel owners rather than operators, are further burdened by furniture, fixtures and equipment (FF&E) requirements that are continually needed to insure that hotel assets remain competitive.

Liquidity has definitely been an issue for lodging REITs. When compared to pre-recession levels, bank lines have contracted and availability is still subject to stringent borrowing and debt service coverage requirements in both bank credit agreements and bond indentures. Until 2003, asset liquidity, the ability to sell hotel properties, was nearly non-existent as uncertainty about future terrorist attacks, SARS and the timing of an economic recovery discouraged lodging investments.

Fortunately, investors interested in positioning their investment portfolios to maximize growth during an economic recovery have committed significant capital to the lodging sector over the last 14 months. During this period, lodging stocks have performed well. In fact, several lodging REITs have successfully accessed the equity markets, including Host Marriott and MeriStar.

Hotel property sales have also picked-up considerably. Lodging companies are capitalizing on investor appetite for hotel assets by selling non-core properties. Starwood, for example, sold more than $1.2 billion worth of assets in 2003 using the proceeds to repay debt.

Access to capital between the fall of 2001 and the summer of 2003 was not good. In fact, many lodging REITs suspended dividends, a practice which they have yet to resume, to address liquidity concerns. The suspension of dividends enabled these companies to improve their liquidity by increasing cash balances at a time when bank line availability was shrinking. However, given two years of cash flow constraints, Fitch is concerned that significant deferred maintenance may exist at the property level which could serve to delay debt repayment. MeriStar recently announced a $250 million capital expenditure program designed to enhance property level performance. Host Marriott acknowledged that some deferred maintenance exists in their portfolio that will likely increase FF&E spending to roughly 7 percent of revenues in 2005, somewhat higher than the normal 5 percent to 6 percent of revenues. Also, a return to profitability for lodging REITs will mean the resumption of dividends minimizing the opportunity for debt repayment.

With few exceptions, leverage for lodging companies increased unabated from the third quarter of 2001 until the third quarter of 2003. Debt to recurring EBITDA, which indicates how many years of earnings at current levels would be needed to repay existing debt, jumped more than a full turn from 3.7x on average at year-end 2000 to 5.1x at year-end 2002. Lodging REITs, which are generally weaker on the credit spectrum, increased leverage two full turns from 4.5x on average to 6.5x on average as a result of declining earnings. If cash on hand were to be used to reduce debt, these ratios would improve marginally. Still, leverage on a book value basis also increased for lodging REITs between 5 percent and 13 percent.

Asset sales appear to be the only remedy for the leverage picture in the near term. Fortunately, lodging companies were well positioned for the recession with limited debt maturing during the worst of the economic and travel malaise. The most problematic financing consisted of bank line renewals that were impacted by financial covenant defaults which occur when a company fails to meet the debt service coverage and leverage requirements contained in their loan documents. The banks continue to keep the lodging REITs on a relatively short leash, though access to capital and signs of improvement in property operations may be easing their concerns.

Assuming no further external shocks to the economy, Fitch is optimistic that lodging credits will be stable in 2004 with a bias toward improvement as property level operations improve and asset sale proceeds are used to repay debt.

Tara Innes is a managing director and
Patricia Wright is a director with Fitch Ratings.