COVER STORY, MAY 2010

MIDWEST HOSPITALITY UPDATE
Although faring better than the coastal regions, the Midwest hotel industry continues to look for signs of a reviving market.
Amy Bigley

While the hospitality industry has experienced an overall decline in the past few years, the central region of the nation has experienced a mixture of the extremes seen throughout the country. The transaction market has dipped well below its high during 2007 and early 2008, but overall the market is faring better than its counterparts, particularly in the coastal regions. As the central region encompasses a wide array of states from Michigan, Illinois and Kansas to Texas and Oklahoma, markets are encountering situations that are unique to its location and economic issues.

The South Central United States was hit with the economic downturn a bit later than the rest of the country, so many of the effects have not reached all the markets yet. Rahul Bijlani, director of Marcus & Millichap’s National Hospitality Group in Houston, Texas, expects that the South Central market will experience a decline in 2010 much like the decline that the remainder of the nation experienced last year.

“We expect the transactions to pick up pace in 2010 due to numerous short sales and distressed asset portfolios hitting the market, as property owners and lenders come to terms with the new market prices,” explains Bijlani.

As for the remainder of the states, market conditions such as conservative development, less price run up and availability of product has allowed the Midwest to stay afloat during the current downturn. Changes in prices and values seem to be less dramatic across the Midwest states when compared to the coastal regions. Industry experts like John Sturgess, COO Hunter Realty Associates in Bloomington, Minnesota, notes that the central United States is a good and steady place for continued investment.

Generally, the Midwest is facing a slow but steady recovery process that is expected to begin this year with a slight uptick in the market.

“It will be a long time, if ever, until we get back to the level that the hotel industry reached in 2007 and early 2008,” says Terry Baltes, president of Dayton, Ohio-based BALTES Commercial Realty. “I think 2010 will be better than 2009, 2011 will be obviously better than 2010 and in 2012 things will sort of be back to normal.”

A challenge facing the transaction market is the continued gap between buyers’ and sellers’ expectations to acquire and unload product. One of the fundamental differences between buyers and sellers is way each side approaches an opportunity based on calculated costs. Sellers, especially developers, focus on real estate value and construction costs, while buyers, which have become more conservative, tend to focus on proven cash flow, value and cap rates, explains Bijlani. Marcus & Millichap’s brokerage team tries to balance these different approaches by analyzing both cash flow factors and cost of construction while using conservative predictions for new hotels without a proven revenue history.

The other side of the tough selling market is the hidden potential for recently and forthcoming transactions to be very profitable for the hotel industry. Buyers who take some risk and buy now will be rewarded later, notes Sturgess. Sellers should also take advantage of the market as well before a larger wave of distressed hotel assets hit the market and drive prices down even further.

Another challenge among sellers and buyers is the misconception of availability of quality product. Many buyers wrongly believe that the market is full of product that can be acquired at a discount, but, in reality, much of the product that is available are deep-discount properties that more than likely should have be closed up a long time ago, notes Baltes. “The quality product is not coming available because it’s owned by good operators that are able to control costs or have not encountered the large decrease some lower-tier properties have experienced,” he adds.

Adam McGaughy, executive vice president with Jones Lang LaSalle Hotels, agrees with Baltes’ notion, noting that although there’s still a large bid-ask spread, it seems to be tightening for the quality product market, as sellers are willing to take a bet on quality branded, full or select-service hotel properties. “If you have a high-end product – Hilton, Marriott, Starwood – you’re going to get a lot of competition that will ultimately bid up pricing,” he says.

One factor helping to drive product availability is the decrease in the Midwest’s overall economy. The economic decline coupled with the tight lending market is causing many banks and owners with non-recourse debts to turn hotel properties over to the bank, notes McGaughy.

Coupling with the bid-ask spread is the lack of available financing that continues to plague the industry, but not without light at the end of the tunnel. The tightened lending climate affects buyers and sellers alike. Buyers are looking for ways to finance transactions and sellers are looking to accept those transactions to get out of existing debt. Developing and maintaining relationships with lenders is one proven way to overcome the tight credit market.

“It’s a case-by-case situation, if a potential borrower has a project where the bank understands the market and borrower then that creates a willingness to place money on the project,” says McGaughy.

Much of the credit crisis also stems from a macro situation as it relates to debt, explains McGaughy. One of the major factors slowing down the transaction pace is the lack liquidity and no debt-market to take out the current debts. “There’s not a problem with equity out there — it’s a debt-driven problem and it’s thawing.”

While completely blaming the federal government for the current situation could be considered a cop out, it is expected that government oversight will have a larger presence — a potentially positive presence — in the market moving forward. Small Business Administration (SBA) incentives and lending are great assets to the hospitality market; although a bit tricky to fully take advantage of. One problem that is coming to the forefront is the reluctance of local and regional banks to take risks on the unsecured portions of SBA loans. Of the few local and regional banks offering financing, 40 to 50 percent down is expected for non-SBA loans and 20 percent is required for SBA-backed financing.

Reviving the hotel industry transaction market alone will not revive the overall industry and many theories exist about the best way to overcome the challenges. Some believe the industry should tackle its current problems head on, notes Sturgess. “That is, we must resolve bad loans before lenders will make more hotel loans,” he says. Additionally, overall demand needs to pick up in the market, which may be a positive effect of the tightened credit market that has resulted in a decrease in construction starts.

One of the most beneficial solutions for the hospitality transaction market is creating and maintaining property values. “Creating value will encourage owners, operators and investors to invest back into their properties to increase the revenue and bottom line to create value going forward,” says Baltes.

Another school of thought is that the industry, as a whole, must recognize when the market hits bottom. McGaughy anticipates that will not be realized until the industry sees RevPAR go up for the first month-over-month, which is not expected to occur until October or November. “Right now is the first time in a long time that you can tell an investor or owner that the value of their hotel real estate is not less than it was 3 months ago,” says McGaughy. “Once RevPAR goes up, people are going to be willing to take a bet on a lot of the assets and you’re going to see aggressive money-chased deals.” Additionally, once the bottom is recognized many inadvertent owners — banks or special servicers — will be able to transact quickly allowing more sophisticated owners and operators back into the market, notes McGaughy.

The interaction of all these theories and ideas will help to ease the stress and tension of the hotel industry in the central region. Patience and conservative efforts, mixed with a sprinkling of risk, will allow the market to rebuild at its own pace.

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