Over-Heated Marketplace for Hotel Investments Continues

By James O’Connell
Principal
O’Connell Hospitality Group, LLC
May 10, 2006

Boston: We are advising clients that have an interest in selling their properties to do so now. This is an excellent opportunity to take advantage of a very aggressive “sellers market”. As soon as the pressure to place equity eases, we’ll be back reviewing fundamentals of hotel guestroom supply and demand as well as immediate returns on investment.

The investment market for hotel property acquisitions continues to be very strong. Properties of all shapes and sizes are trading for aggressive prices. Direct Capitalization rates are low and projections are being pushed further out into the future. The interesting situation that hoteliers in New England are experience is that the investment market may be frothy but hotel operating performance is not.

Private equity continues to be in great supply. This has caused pressure to place the newly raised capital. This pressure has caused investors to look out beyond the traditional thirty-six month horizon and HOPE that things will improve sixty to eighty four months out so that the returns promised to equity investors can be realized.

We find buyers justifying acquisition prices based on the discount to the “Cost to Replace” and not on fundamental growth projections with improvements in profit margins. The rush to bulk up on Marriott and Hilton product has caused values to skyrocket. Unfortunately, New England’s average room rates and annual average occupancies remain in the doldrums.

The epicenter of the hotel market, Boston, has experienced slow, steady growth over the past three years. However, suburban Boston/Rte 128 corridor and Interstate 495 markets have not bounced back as well. OHG surveyed 5 full service hotels in the northeast I 495 marketplaces this month. According to Smith Travel Research, this competitive set achieved a 58% occupancy and a $101 room rate, year end, 2005. These statistics do not excite anyone. Despite this lackluster performance, we continue to attract investors.

Projections that show mid-teen returns in years five through seven are being purchased, despite present day negative cash flow performance. Return on existing cash flow or “Direct Cap Rates” have dipped into mid-single digits for large full service hotels and Upscale Select Service” brands the price on a “per room” basis is winning the argument over present day cash flow. Justification such as “we can’t build it for that price” is driving the acquisition criteria.


We are all waiting for better than average increases in market performance. Downtown Boston is performing well with almost a 10% RevPar increase. However, we don’t see suburban room demand increasing in a significant way (over 5% per year) in 2006 or 2007. Traditionally, we enjoyed a very healthy “spillover” effect when Boston sold out during large conventions or seasonal peaks such as fall foliage or university related events. We are cautious about the future of outlying areas because this will change very soon when the new supply of +/- 3,000 hotel rooms begins to come on line on Boston, primarily situated on the waterfront near the BCEC.

Other New England areas have cause for concern as well. After September 11, 2001, New Englanders chose not to fly, but to drive to vacation spots in the Berkshires, Cape Cod and the Coasts of Maine and New Hampshire. Now that gasoline is over $3.00 per gallon, “drive-to” locations will be feeling the pinch. Hoteliers will have to get very creative in order to attract vacationers and those special packages cut into profits.

The confluence of low interest rates, a plethora of investment capital and positive trends in the market have us believing that owners should consider “taking some money off the table” by taking advantage of strong investor sentiment that is willing to chase returns. We would like to think that this phase in the real estate cycle will last forever but we know that all good things must come to an end and all the caution flags have been raised.