by Lesia Bates and Margaret Holloway

After a prolonged period of turbulence, the U.S. lodging property sector is showing signs of resilience as evidenced by strong RevPAR growth and occupancy increases, albeit modest. On average, RevPAR grew by more than 5 percent during 2000, and occupancy inched up to 65.5, from 65 percent. Demand has grown due to the strong U.S. economy, which fuels both tourism and business travel. At the same time, construction has slowed in most markets from the pace of only a few months ago. Lodging firms' increased focus on branding, technology, reservation systems and customer loyalty programs are additional means to boost profitability. These positive trends resulted in higher than anticipated earnings performance (fueled by both top and bottom-line performances) for most lodging companies in 2000.

While long-term industry fundamentals have improved, the lodging sector remains somewhat friable. Analysis of hotels applies to a shorter-term horizon than for other property types, and the current vigor should not be assumed to be a permanent, long-term condition. Lodging REITs, relative to other property sectors, are more dependent on the underlying performance of the economy, and an anticipated slowing of the economy could result in weakening lodging demand, and in turn, more moderate RevPAR growth.

Moderating supply growth related primarily to the liquidity crisis of 1998 and tighter lending standards is a current plus. REITs with significant geographic, brand and revenue diversification and scale, strong financial flexibility and good access to capital appear to be the best positioned given current circumstances.

Cash Flow

Like all property sectors, hotels are subjected to real estate market cycles. After recovering from substantial oversupply in the early 1990s, the hotel sector has delivered impressive results, yet remains volatile relative to most other property types. In contrast to most other property types, lodging properties are closer to being operating businesses than real estate assets. Not only is lodging net operating income less predictable because of daily changes in occupancy and room rates, but hotel operations are also management- and capital-intensive.

These factors affect the hotel sector's cash flows and returns. Long lead times for construction projects, short lease terms (daily changes in room rates), unanticipated shifts in economic conditions and operating costs are also important factors.

Hotels are heavy users of capital due to the continuing need to refurbish and to meet guests' shifting needs, such as in-room technology. As such, high leverage, limited available capital and significant new supply could potentially erode lodging REITs' profit margins.

Diversification and Brand Quality Are Key

Diversification—geography, brand and revenue streams—remains an important means for assessing lodging REIT. Given the cyclical nature of the hotel industry, diversification is important because it can provide some stability to revenues and earnings through economic and real estate cycles. For example, geographic diversification can help to reduce the effect of regional weakness and overbuilding in a given market.

Brand segmentation, coupled with brand quality, also helps lodging firms to weather an economic downturn. By offering a wider range and budgets of available hotel products, lodging REITs can appeal to a broader range of customers to preserve revenues and occupancies during market cycles. Some firms have chosen to focus on specified brands. Host Marriott, for example, has been successful in strengthening its franchise value by focusing on well-established brands in narrow segments of the hotel industry.

Diversification may also be achieved through consolidation. Meristar Hotels and Resorts (through its paper-clipped operating company) and FelCor Lodging Trust are notable examples. However, in some cases, consolidation may weaken a firm's financial profile over the near-term , but risks should be offset by improved geographic, brand and revenue diversification over the long-term.

The level of diversification a REIT is able to achieve weighs heavily in our assessment of a REIT's ability to withstand economic downturns. The absence of diversification is a credit negative, and must be offset by other factors, such as strong financial flexibility and low leverage.

RMA Is a Plus

We believe that the REIT Modernization Act (RMA) should positively benefit lodging REITs. Notably, the RMA will allow REITs to enhance shareholder value through additional revenues captured in taxable subsidiaries. Hotel REITs will be able to replace independent lessees with a lease to a taxable REIT subsidiary (TRS) of the parent REIT, which should help to simplify hotel REITs' operating structure and to improve reporting of earnings. By consolidating out lessees, lodging REITs will be able to exercise greater control.

REITs' profitability also should be enhanced as hotel property firms will be able to reduce leakage (retain lessee payments), which should translate into roughly 1 to 3 percent of additional hotel revenues. Most lodging REITs have converted or are converting existing leases from their operators to management contracts. This structure should result in overall improvement and alignment of interests between the REIT and the hotel operator.

While TRSs will give lodging REITs, broader license to expand into businesses currently out of reach or greatly constrained, cash flows may be more volatile. Under the RMA, cash flows will no longer be dependent on top-line revenue performance and operating costs, but on the hotel's cost structure. Rising operating costs (e.g., labor and energy) combined with slowing revenue growth could lead to a decline in profit margins and, in turn, negatively affect REITs' earnings performance.

For now, we expect service revenues from TRSs to be modest compared to the rental payments REITs receive, but we believe that, over time, TRSs will grow and will diversify cash flow. The growth of ancillary business should allow greater diversification of REITs' revenue sources, mitigate concentration risks, and help them to serve tenants' emerging needs.