By Lesia Bates Moss

U.S. lodging REITs' performance has been under pressure since the latter part of 2001 as firms have wrestled with the unpleasant fact of negative RevPAR (revenue per available room) growth in many of their markets. Although occupancy rates climbed back to respectable levels in 2002, average daily rates (ADRs) remain under pressure as weak economic conditions and geopolitical turmoil continue to impact business and leisure travel demand.

Moody's Investors Service's outlook for the ratings of lodging REITs remains gloomy, reflecting our expectation that a recovery in lodging demand will take some time to emerge given that fragile economic conditions, the threat of further global conflicts and terrorism continue to overhang weak demand from the business traveler. Recent economic indicators, such as lower GDP growth expectations, declining consumer spending and confidence, and weak corporate profits, will likely put further pressure on near-term demand and on lodging REITs' performance as consumers and businesses pull back on spending.

No Relief From Slowdown

Of the factors listed above, the lingering economic downturn has probably hit lodging REITs' performance the hardest, compared to lodging C-Corporations or other real estate property types. A number of firms reduced their performance estimates in 2002 as a result, and several (but not all) lodging REITs entered 2003 with strained liquidity positions. Continued uncertainty surrounding the economy and the impact of war is causing many REITs' senior managers to take conservative positions on 2003 performance.

Overview of Moody's Rated Lodging REITs
Company Name	Ticker	Moody's Senior Debt Rating	Total Assets 2002 YE	Cash and Equivalents 2002 YE ($000)	Total Debt 2002 YE ($000)	Credit Lines Available 2002 YE ($000)
Equity Inns, Inc.	ENN	B3*	774,451	5,916	362,881	125,000
FelCor Lodging Trust, Inc.	FCH	Ba3	3,780,363	66,542	1,877,134	300,000
Hospitality Properties Trust	HPT	Baa3	2,403,756	7,337	473,965	350,000
Host Marriott Corporation	HMT	Ba3	8,316,000	361,000	5,638,000	300,000
La Quinta Properties	LQI	Ba3	2,548,000	10,000	665,000	225,000
MeriStar Hospitality Corporation	MHX	B2	2,943,548**	54,300	1,654,102	150,000
RFS Hotel Investors, Inc.	RFS	B1	642,655	1,938	291,229	140,000
Winston Hotels, Inc.	WXII	B3*	357,442	1,510	138,706	125,000
* Preferred Stock rating * *As of 9/10/02 Source: Moody's, SNL Securities and company press releases.

As it seems likely that poor economic conditions will persist for some months to come, Moody's expects all lodging firms, including REITs, to continue focusing on expense control and liquidity management in 2003. In fact, many firms began employing initiatives to reduce corporate and property level overhead in order to preserve their margins immediately following the terrorist attacks of September 11. These initiatives included staff reductions, reduced hours of operations and offering flex time.

Nevertheless, increases in labor, energy and insurance costs, in particular, for these firms remains high at the same time as the economy is ailing, making even the most drastic cost-cutting programs limited in their impact. Given the generally high fixed costs of operating hotels, firms may find it challenging to reduce costs much more. As a result, the operating margins of hotel firms will likely come under greater pressure if the recovery is prolonged.

Outlook For Credit Quality

The negative outlook for the lodging REIT sector reflects the firms' weak profit profiles and expectations of continued performance pressure. Several lodging REITs face this difficult period with weak liquidity positions as seen in their low cash balances and limited access to alternative liquidity due to covenant violations in bank and bond agreements. However, some REITs, such as Host Marriott Corporation, have built sound liquidity positions—positions that will help them get through this time of stress.

In terms of access to liquidity, lenders' willingness to provide certain financial covenant amendments to these firms over the past several months has been encouraging. The bond market was also a big plus for lodging REITs in early 2002, followed by renewed activity in the CMBS market thus far in 2003. There is concern about firms' ability to access these capital sources in the future, however, given further anticipated weakness in the sector's performance. Some lodging REITs may soon find themselves with more limited capital access to meet their near-term financing requirements.

These considerations are factored into our ratings of the lodging REITs. The overall ratings profile for the eight rated REITs (tracked by Moody's as shown in the chart below) involved in the lodging sector is below investment grade—in the low "Ba" range, representing approximately $9 billion of rated long-term debt. Those firms that are well capitalized and have moderately low leverage should be positioned to maintain their ratings. For example, Hospitality Properties Trust benefits from a strong balance sheet and its net lease business model has helped to cushion the negative effects of weak demand.

Diverse Holdings Help

In this environment, all lodging REITs' performances are being hurt, regardless of their level of portfolio diversity. Firms such as RFS Hotels, FelCor Lodging, La Quinta Properties and MeriStar Hospitality, for instance, are experiencing weaker-than-anticipated recovery in RevPAR, reflecting geographic concentrations and/or their reliance on business transient and international leisure travel demand.

In contrast, Host Marriott's focus on specified brands in limited segments of the hotel industry has cushioned the blow of the recession. Because many of its hotels are larger and located in major travel markets, Host Marriott has benefited from the stronger recovery in demand for large group and convention business. Likewise, the drop off in demand has less negatively impacted Equity Inns' focus on limited-service hotels, many of which are located in drive-to markets.

Lodging & Resorts
# of REITs	16
Market Cap.*	7,227,503
Industry Market Cap.*	157,851,234
% of Industry	4.6%
Yield	5.4%
YTD Total Return	-19.7%
One Year Return	-32.6%
Three Year Return	0.6%
Five Year Return	-56.7%
Average Monthly Trading Volume (shares)	272,699,000
Weighted FFO Growth (2002–2003)	-17.5%
*These figures represented in thousands. Data as of Feb. 28, 2003. Source: NAREIT.

In the long run, lodging REITs with significant geographic, brand and revenue diversification and scale, strong financial flexibility (in the form of cash on hand and a lack of near-term debt maturities) and good access to capital should find themselves best able to meet this tough market.

A number of factors should prevent the lodging sector from experiencing a major crisis. Hotel supply levels have trended down considerably, occupancy appears to have stabilized, and tighter lending requirements should further help to control supply/demand imbalances. Barring certain political or security events, hotel demand should not decline much further, although ADRs are expected to remain weak through 2003.

While earnings visibility remains limited, investors can take comfort that when the industry recovers, lodging REITs, as well as other lodging companies, should experience accelerated improvement in profit performance due to the positive impact of operating leverage and favorable supply/ demand outlook for the sector. Factors that could lead to improvement in lodging REITs' ratings and/or outlooks hinge on sustainability in demand recovery, resolution surrounding geopolitical events and improvement in firms' liquidity and credit profiles.

Lesia Bates Moss is a senior vice president in the Real Estate Finance Group at Moody's Investors Service.