By Lynn Novelli

Sept. 11, 2001 cast a long shadow over the lodging industry, sending the industry’s metrics into a long downslide. However, after nearly two years of poor performance, lodging finally started to come out of the slump in the second half of 2003. Once under way, the recovery quickly gathered steam, and by early 2005 lodging REITs were experiencing growing demand and rising room rates.

Now, six years after the tragic attack, lodging REITs are definitely healthy again. “After hitting that trough in 2003, lodging industry fundamentals have been in an upswing,” says John Arabia, a principal with Green Street Advisors. “Growing demand and limited growth in supply have propelled occupancy levels upwards and allowed hotels to raise room rates.”

Lodging Sector Snapshot*
Occupancy rate	63.9%	-1% from 2006
ADR	$103.36	+5.3% from 2006
RevPAR	$66.06	+4.2% from 2006
*as of April 30, 2007 Source: Smith Travel Research

Occupancy, average daily rate (ADR) and revenue per available room (RevPAR) climbed steadily through 2004, 2005 and 2006. PricewaterhouseCoopers and Smith Travel Research reported a record-setting 8.0 percent growth in RevPAR for 2006, the largest increase in 20 years.

Through this period, gains in RevPAR were driven primarily by room rate increases, creating acceleration in profitability as well. According to PricewaterhouseCoopers, the lodging industry saw a 25 percent increase in profitability in 2005, followed by a 21 percent increase in 2006.

Now, midway through 2007, it is clear that the momentum is continuing, although the pace of growth has slowed. “The industry continues to move forward, overcoming the challenges it faced as a result of numerous natural disasters and human conflicts over the past few years,” says Michael Fishbin, national director, hospitality and leisure, Ernst & Young. “Industry fundamentals remain strong.”

Occupancy Still Strong

The new room supply pipeline is flowing again. Encouraged by solid profits in 2005 and 2006, strong lodging fundamentals and interest from capital markets, many lodging REITs are moving ahead with construction projects that had been in a holding pattern.

Lodging
# of REITs	14
Industry Market Cap (in thousands):	$31,863,968
% of industry	8.3%
Yield	4.33%
YTD Total Return	8.86%
One-Year Return	28.26%
Three-Year Return	28.40%
Five-Year Return	16.62%
Average Daily Trading Volume (Shares)	794,173
Source: NAREIT data as of May 31, 2007

Lodging Econometrics reported a 1.8 percent supply increase in 2006 and is forecasting a 2.5 percent increase for 2007. This projected increase will include approximately 1,087 new hotels with 116,000 rooms rolling out the welcome mat for guests this year, a 40 percent increase over 2006. The total supply pipeline, according to Smith Travel Research, includes upwards of 3,700 projects with 511,000 rooms.

All of this new supply is putting pressure on occupancy. “Although occupancy rates are still strong, growth in this metric is relatively flat and will continue for the remainder of the year,” Fishbin says.

Even with the expected flurry of new construction, the good news for hotel owners is that analysts do not expect supply to exceed demand in the near future. Smith Travel Research forecasts a 1.9 percent compound annual growth rate in the number of rooms through the end of 2008, which should keep pace with anticipated moderate demand growth.

The surge in supply is moderated to some degree by escalating construction costs as developers encounter higher prices for supplies, fuel and labor. “As a result, mixed use, such as luxury projects combining hotel and residential, are popular with developers who are facing costs of as much as $500,000 per key,” Fishbin says.

New supply varies by geographic market and property type, with much of the construction activity focused on mid-scale limited service and luxury properties in the most desirable markets such as Chicago, New York City, Orlando, San Diego and Washington, D.C.

“The REITs that will outperform are those that develop new assets in areas where it is very difficult to add rooms,” says Jeffrey Donnelly, director of equity research for Wachovia Capital Markets. “Growth in supply still breaks down to a few selected properties in a handful of markets.”

Room Rate Growth
Luxury hotels, which dominate the portfolios of the larger cap lodging REITs, will continue to exercise the strongest pricing power in 2007 and will lead in ADR. While industry-wide ADR growth is expected to be between 5.8 percent and 6.0 percent, luxury hotels should enjoy room rate growth in the 8 percent to 10 percent range, according to Ernst & Young forecasts.

“High demand for these rooms coupled with their relative insulation from general economic fluctuations means that ADR for luxury hotels can continue to increase at a rate faster than all other market segments,” says Chris Woronka, vice president and analyst, Deutsche Bank North America.

Similarly, hotels in key market locations also will enjoy larger and faster increases in ADR throughout 2007 and into 2008. Manhattan continues to be the top performer among all major markets, gaining in occupancy and ADR thanks to strong demand from corporate travelers and an influx of new, luxury class hotels with high ADRs.

Although hotel owners as well as investors have become accustomed to 6 percent to 8 percent gains in room rates in recent years, these kinds of increases are a deviation from the norm. Industry statistics show that prior to Sept. 11, the historical average growth in ADR was just 3 percent to 4 percent annually.

“As business recovered after Sept. 11, we started to see rapid growth in room rates, particularly because competition was low,” Donnelly says. “Now, at this stage in the recovery, ADR will continue to grow but at a slower rate.”

Occupancy Forecast for 2007
	2000	2001	2002	2003	2004	2005	2006	2007
Occupancy	63.3%	59.7%	59.0%	59.2%	61.3%	63.1%	63.8%	63.9%
ADR Growth	5.4%	-1.5%	-1.5%	0.1%	4.1%	5.4%	6.8%	5.9%
RevPAR Growth	6.1%	-7.0%	-2.7%	0.4%	7.9%	8.5%	8.0%	5.9%
Source: PricewaterhouseCoopers

Respectable RevPAR Growth
On the heels of 2006’s dramatic 7.6 percent growth, RevPAR was somewhat sluggish during the first quarter of 2007, exhibiting modest year-over-year growth of 4.5 percent, according to Smith Travel Research. That was still a respectable level for one of the slower travel seasons of the year, Fishbin notes, stressing that the rate traditionally picks up through summer and into the end of the year.

By year’s end, analysts are forecasting 5 percent to 6 percent growth in RevPAR, tracking with anticipated ADR expansion. Room rates contributed to 64 percent of RevPAR in 2005, growing to 69 percent in 2006. This year, with occupancy rates flattening, ADR’s contribution to RevPAR will “head north of 80 percent,” Fishbin forecasts.

At the lower end of RevPAR growth, the economy and upper-upscale segments are expected to finally exceed their pre-2001 RevPAR levels. Ernst and Young forecasts 5.3 percent and 5.5 percent RevPAR growth for these segments, respectively.

Fishbin summarizes the lodging outlook optimistically. “The industry’s sensitivity to the healthy business environment, increasing business travel and marginal supply growth in 2006 are anticipated to yield a solid position for RevPAR in 2007, albeit below the gains of 2006.”