Reservations about the economy; hotel operating results are strong, but a softening U.S. economy is the wild card in the hotel industry's outlook.

The nation's lodging industry is poised to register a third consecutive year of record net profits in 2008, according to the Washington, D.C.-based American Hotel and Lodging Association (AHLA). * At the same time, lodging operators are keeping an eye on volatile economic conditions. "A downturn in the economy is the only thing that could hurt us," maintains Joseph McInerney, chief executive officer and president of the AHLA. * McInerney says the industry tallied $26.6 billion in 2006 net profits followed by $26.9 billion in 2007-both records--and is projected to set another record of $29.9 billion in 2008. * "It's a very strong outlook, and we won't see hoteliers sacrificing rates as they did in the past following 9/11," he says. McInerney cites robust business and leisure travel markets as fueling the upswing. Of special note are the foreign travelers flocking to the United States, enjoying buying power made possible by the weak dollar. * Smith Travel Research (STR), Hendersonville, Tennessee, reports a 5.7 percent national gain in revenue per available room (RevPAR) for 2007 over 2006. The gain is due 100 percent to rate increases, the organization explains.

Moreover, STR forecasts a 5.2 percent increase in 2008 Rev PAR over 2007.

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The upbeat assessment continues in the U.S. Lodging Industry Report and Forecast issued Dec. 13, 2007, by Pricewa-terhouseCoopers (PwC), the New York-based accounting giant that tracks the lodging industry. PwC forecasts a 5.1 percent increase in 2008 RevPAR over 2007, and says 2007 RevPAR was up 5.5 percent over 2006.

While the outlook appears rosy on the operational side, it's a somewhat different story on the financial side.

Transaction activity slows

McInerney says the widespread credit market disruptions affected the lodging market by slowing the funding for new hotels. "But we didn't overbuild dramatically coming out of the last recession,'' he notes.

Ted Mandigo, president of T.R. Mandigo & Co., Elmhurst, Illinois, hotel industry consultant, agrees. "It's put a damper on some projects because lenders have tightened credit requirements, loan-to-value [LTV] is lower and they want more equity."

John Keeling, senior vice president in the Houston office of San Francisco--based PKF Consulting, international hotel consultant, comments, "There's been a disruption on transactions. All lenders are becoming more conservative, tightening up on LTVs and debt-coverage ratios. Lending terms are longer and more expensive, making it harder to purchase and build properties."

Nicholas Bertino, vice president, commercial mortgage group, in the Carlsbad, California, office of San Francisco-based Wells Fargo Bank, agrees, saying, "There's been a disruption in hotel market financing. When the roof fell in on the CMBS [commercial mortgage-backed securities] market, transactions slowed markedly after mid-2007."

"Lenders are not willing to go too high [on] LTVs, the cost of capital is high and borrowers need more equity," he says.

Thomas McConnell, senior managing director-hospitality division of New York-based Cushman & Wakefield Inc., is another who points out that hotel lending has dried up significantly as a result of the credit crunch. "Spreads have doubled, and LTVs have gone down," he says.

A more positive assessment comes from Arthur Buser, director and head of the Los Angeles-based West Coast division of New York-based Jones Lang LaSalle Hotels. While the hotel industry is concerned over the credit market and state of the economy, fundamentals remain strong for operations, he says. "On the financial side, hotel mega-deals have come to a halt--but single-asset sales and portfolios remain viable. Some buyers are waiting for pricing deals as others take advantage of less competition," he says.

Steven Marx, president of Chicago-based Hotel Source Inc., broker-consultant, agrees that lenders are more cautious, but says they're still fairly robust on hotels.

Further observations on the hotel market's financing dynamics are offered by Suzanne Mellen, managing director in the San Francisco office of Mineola, New York--based HVS International, hotel consulting and evaluation firm.

In her January 2008 Hotel Cap Rates and Values in a Changing Market Environment report, Mellen says the tightening of credit and stricter underwriting has increased the cost of capital and made it more difficult to obtain. She cites lower LTVs reduced to the 65 percent-70 percent range, from 75 percent-80 percent previously.

Equity investors must contribute a greater portion of the capital required to close transactions. Equity yields have declined as a result, due to decreased leverage and the need to close a portion of the gap between buyer and seller expectations. Increased uncertainty about future earnings may change this paradigm, she says.

Has the market hit a peak?

Has the hotel market reached a peak, and if so, what are the ramifications? Industry sources interviewed during the first quarter of 2008 offered varying views.

"Peaks usually come with overbuilding, and the only way to peak now is if the economy starts to tank. Otherwise, the cycle isn't going to end," says McInerney.

Keeling has a different view. "We're at the top of the cycle now. The question is, where do we go from here? Occupancies, average daily rates [ADRs] and RevPAR all set records in 2007. A major recession could affect the market by causing a fall-off, but we look to remain steady through 2008," he predicts.

McConnell says, "History tells us the market runs in four-to five-year cycles, so there's likely to be a peak within the next 18 months. It would cause a decline in RevPAR."

"We can't really tell at this point whether hotels have peaked, because of volatile market conditions," says Bertino.

Marx says the industry is nearing a peak in many markets. Buser says the peak in transactions has already passed. He says total hotel transaction volume will go down in 2008 with the decline in mega-deals, but he looks for the number of single-asset transactions to rise.

Other sources join McInerney in observing that the hotel market enjoyed record consecutive years in 2006 and 2007. Reasons cited include increases in business and leisure travel; demand exceeding supply in many markets; and renovation and repositioning of hotel properties to increase their appeal. Some, however, are less bullish than McInerney on the 2008 outlook, citing economic conditions.

The 2008 Emerging Trends in Real Estate Report, co-produced by the Washington, D.C.--based Urban Land Institute (ULI) and PwC, points out that a significant supply of new rooms is on the horizon. (McInerney says there were 205,000 rooms under construction as of first-quarter 2008.) The report adds that the lodging sector needs a solid economy to keep from getting swamped in its latest development wave. "History has shown that this industry typically busts after booms," the report concludes.

Business travel increases

The health of the hotel market is closely linked to business travel. American business was in the air and on the road in growing numbers in 2007, according to the Alexandria, Virginia--based National Business Travel Association (NBTA).

In its U.S. Business Travel Overview & Forecast, updated for November 2007, the NBTA says business travel will continue to increase through 2008. Higher hotel rates will be the primary driver of increased travel spending. A second driver will be an increase in the number of business trips, says the NBTA.

About 60 percent of the travel managers surveyed by the NBTA indicate they expect more travel for their companies in 2008. That translates into more hotel business. Additionally, most travel managers surveyed say they expect to increase their hotel expenditures in 2008 because of higher hotel rates coupled with more frequent trips.

The frequency of business and leisure travel is documented by the Orlando, Florida--based Y Partnership (formerly Yankovich Inc. and Yesawich, Pepperdine, Brown and Russell), an advertising and public relations agency serving the travel industry.

In its May 2007 National Business Monitor report, Y Partnership says more than one-third of 1,445 business travelers surveyed expect to take more trips in 2008 than 2007. Of 1,882 travelers surveyed in its separate 2007 National Leisure Travel Monitor, the organization says 33 percent plan to take more trips in 2008 than 2007.

Rising gas prices have been well-publicized, but experts are discounting them having any appreciable effect on hotel occupancies. McInerney comments, "People will travel if gas is available, no matter what the price. They just may take shorter trips."

Mandigo adds, "Gas prices are not significant. People will travel and don't view gas as a major cost. They look at the prices and just shrug their shoulders."

PwC, though, calculates that when real gasoline prices increase by 10 percent, lodging demand decreases by 0.5 percent.

A major source of hotel market data is the series of quarterly assessments of U.S. property markets entitled CMBS: Red-Yellow-Green TM Update, issued by New York--based Moody's Investors Service.

Moody's divides hotels into full-service and limited-service segments. In its fourth-quarter 2007 report, Moody's reported there's a weakening in demand for full-service hotels and just the opposite for limited-service hotels, where demand is exceeding supply.