By Tara Innes and Jane Cotroneo

After three years of challenging times for a lodging sector shaken by weak economic conditions, geopolitical instability, health and terrorism concerns, 2004 showed significant improvement. Industry wide revenue per available room (RevPAR) increased 7.5 percent through September 2004 signaling the arrival of a lodging recovery. It was the first increase for RevPAR for the period after three straight years of declines, according to Smith Travel Research.

The initial stages of a turnaround were detected in the latter half of 2003 after immediate fears of SARS and the war in Iraq subsided. Fitch Ratings, viewing signs of life in the lodging industry, raised the outlook of Starwood Hotels & Resorts (NYSE: HOT) and La Quinta Corporation (NYSE: LQI) from negative to stable in late 2003. Since then, the recovery has gained momentum.

In 2004, the improving economy returned companies to more normal commerce and business activity. Lodging demand from the business traveler, the segment that dropped the most in the downturn, began to return. The rebound in the business traveler segment, the industry’s highest-paying customer base, is contributing to ongoing room rate increases and adding to the demand and occupancy increases previously created solely by the earlier return of the resilient leisure traveler. Rising international travel to the U.S., aided by favorable exchange rates, is also proving beneficial to the industry.

Lodging & Resorts
# of REITs	17
Market Cap. (in thousands)	$14,510,924
Industry Market Cap. (in thousands)	$275,803,588
% of industry	4.9%
Yield	2.4%
YTD Total Return	21.2%
One-Year Return	29.2%
Three-Year Return	18.4%
Five-Year Return	15.8%
Average Monthly Trading Volume (Shares)	4,864,429
Source: NAREIT. Data as of Nov. 30, 2004

Fundamentals Are Bouncing Back

Stronger demand and limited new supply has set the stage for firming fundamentals in the lodging sector. Scarce financing and higher construction costs have restrained new construction. Smith Research reports industry room supply increased 1.1 percent January to September 2004 while demand increased 4.8 percent September year-to-date.

Occupancy has been steadily recovering but it is the more recent gains in average daily room rates (ADR) provided by the return of the business traveler that have improved margins. These gains in RevPAR, a key measure of industry health, reflect the combination of occupancy and average room rate increases. Helped by a strong September, occupancy rose to 67.1 percent for the quarter ending Sept. 30, 2004, up 2.6 percent from one year ago and ADR rose 3.6 percent to $86.32. Industry RevPAR growth for the quarter was 6.4 percent.

Barring any unforeseen shocks, the future looks promising for the hospitality sector. However, rising hotel operating expenses will slow profit margin gains moving forward as payroll expenses have moved higher and constitute the largest component of hotel costs. Insurance and tax increases have also pressured profits. Hotels will have other extraordinary expenses stemming from the need to restore services that were previously eliminated in an effort to reduce costs. Services such as health club facilities, food and beverage offerings and even restaurants, concierge, laundry and other services were sacrificed.

Fortunately hotel revenues have the ability to grow faster and outpace escalating expenses, but it may take another 18 months for true pricing power to take hold. Companies with exposure to major urban markets are especially poised to raise room rates as the business traveler segment comes into full swing. The luxury market is also showing the greatest opportunity for revenue gains as occupancy increases.

Another factor to consider regarding the pace of the recovery is the acceleration of new development. Stronger earnings performance is already sparking renewed interest in construction. Property & Portfolio Research predicts supply additions over the next five years to average a moderate 1.4 percent of inventory with a heavier volume toward the end of the forecast period. Yet even with this renewed interest in hotel construction, occupancy levels are predicted to steadily increase to a healthy 69 percent by year-end 2008.

Managing Cash Flow

Greater cash flow is now starting to provide companies with the ability to tend to delayed capital expenditure programs. During the three years of declining revenues, lodging companies reduced spending including budgets for furniture, fixtures and equipment (FF&E). Companies will need to catch-up and take care of FF&E items such as hotel décor and beds, as well as other capital improvement projects if they are to remain competitive, and capture market share to generate earnings growth.

Even leading operators such as Hilton and Starwood Hotels & Resorts had to manage through lean times with reduced capital expenditures as well as other cost cutting and asset sales. Now they are redirecting their attention. For example, Hilton’s capital expenditure budget was steadily reduced to $275 million in 2004 from $398 million in 2003, $419 million in 2002 and $509 million in 2000. However, along with their recent positive earnings announcement, Hilton has announced it is increasing 2005 capital expenditures allocations to $430 million.

In addition to funding capex, alternate choices for managing the more robust returns come from companies such as LaSalle Hotel Properties (NYSE: LHO). In a July 2004 news release, LaSalle announced a dividend increase stating its dedication to being an incoming-producing company. Starwood chose to repurchase common stock in the third quarter worth approximately $146 million. The company is authorized to repurchase up to $374 million of additional shares over the next few years.

Restoring the Balance Sheet

Liquidity and credit profiles are two key factors that could lead to improvement in lodging ratings. While it is clear that earnings are improving, it may take a little more time for lodging REITs to restore their balance sheets to historic levels. Three consecutive years of RevPAR declines, resulting in substantial deterioration of operating results, did more than reduce capital expenditure programs, it eroded firms’ debt protections, reducing asset and debt service coverage levels.

Cash flow pressures for lodging REITs had been particularly acute from 2001 to 2003. 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.

Liquidity is ample now as lenders and investors demonstrate interest in an industry with improving operating margins and greater cash flow. Bank line renewals, previously impacted by financial covenant restraints, are now more accessible. Loan spreads have tightened for those companies with good occupancy in strong markets. Lodging companies have more choices in their access to capital. Hotel property sales are well received. MeriStar Hospitality disposed of 18 hotels for $130 million in the first nine months of 2004. FelCor Lodging Trust Incorporated (NYSE: FCH) has also been an active player, selling 15 hotels for $127 million and has identified 19 other hotels for sale.

In addition, lodging stocks are performing well and providing REITs with access to the equity markets. FelCor tapped into this resource as well, issuing preferred stock in the third quarter 2004.

Listed Lodging Companies' Debt/Recurring EBITDA
Company Name	Ticker	2000	2003	2004*
REITs
Boykin Lodging Company	BOY	4.3	6.6	5.4
Equity Inns, Inc.	ENN	4.1	4.9	4.9
FelCor Lodging Trust Incorporated	FCH	4.1	9.7	7.3
Hospitality Properties Trust	HPT	1.9	2.9	2.4
Host Marriott Corporation	HMT	4.7	8.6	8.1
Humphrey Hospitality Trust, Inc.	HUMP	4.7	5.6	5.9
Innkeepers USA Trust	KPA	2.2	3.5	3.3
LaSalle Hotel Properties	LHO	3.9	4.7	3.4
MeriStar Hospitality Corporation	MHX	4.9	10.3	9.6
Winston Hotels, Inc.	WXH	3.4	3.4	2.8
REITs Weighted Average		4.1	7.2	6.4
C-Corps
Choice Hotels International Inc.	CHH	2.6	1.9	2.3
Hilton Hotels Corporation	HLT	4.4	4.6	3.7
Hersha Hospitality Trust	HT	5.4	5.7	5.7
Jameson Inns, Inc.	JAMS	5.6	7.1	7.5
John Q. Hammons Hotels, Inc.	JQH	6.5	6.5	6.0
La Quinta Corporation (REIT&C-Corp)	LQI	4.1	5.6	4.9
Lodgian, Inc.	LGN	5.8	15.4	8.3
Marriott International, Inc.	MAR	1.8	2.1	1.8
Orient-Express Hotels Ltd.	OEH	3.4	8.3	6.6
Starwood Hotels & Resorts Worldwide	HOT	3.6	5.3	4.4
Wyndham International Inc.	WBR	5.9	11.7	8.1
C-Corps Weighted Average		3.8	5.0	4.1
All Lodging		3.9	5.7	4.8
*SNL Data as of Nov. 8, 2004 for 3Q04. Humphrey Hospitality Trust, Hersha Hospitality Trust, Jameson Inns, Inc., John Q. Hammons Hotels, Inc. and Lodgian, Inc. data as of 2Q04. Marriott EBITDA from annual reports.

Some companies, such as FelCor, have used proceeds from equity issuance, asset sales and improved earnings to fund debt reduction but ratios remain above pre-recession levels especially for lodging REITs. The table below highlights the changes in debt to recurring EBITDA (earnings before interest depreciation and amortization) among a select group of hotel companies. It is interesting to compare the top of the cycle in 2000 to the bottom in 2003 and to see a rebound in 2004. The sample represents 21 major lodging companies with available financial data throughout this time period.

Debt to recurring EBITDA indicates how many years of earnings at current levels would be needed to repay existing debt. Overall, the sample shows Debt/EBITDA at 3.9 in 2000, rising to a more challenging 5.7 by 2003 and recovering to some degree to 4.8 in 2004 (according to data available as of Nov. 8, 2004). It is also interesting to distinguish between the credit profiles of C-Corps and REITs. The REITs in our sample averaged 4.1 in 2000, deteriorating to 7.2 by 2003 and modestly improving to 6.4 in 2004. Lodging REITs still have a way to go to reach pre-recession debt levels. C-Corps are faring much better. The sample shows Debt/EBITDA for C-Corps at 3.8 in 2000, rising to 5.0 in 2003 and back to near pre- recession levels of 4.1 in 2004.

One explanation for the lagging performance in lodging REITs’ debt profile is the fact that a return to profitability for lodging REITs requires them to resume dividend payments. Dividend payments delay debt repayment. It is also expected that industry wide in 2005, companies will need to allocate in excess of normalized averages of 4 percent to 5 percent of revenues to FF&E, in an effort to compensate for prior years of forced restraint in this area. This will cut into cash flow and also delay debt repayment.

Looking ahead, cash flow and management willingness are keys to reducing debt levels. Fitch is optimistic that as steadily improving demand drives room rates higher, the lodging industry will continue to enhance RevPAR and profitability, enabling companies to restore balance sheets to pre-recession levels.