By Lynn Novelli

Lodging REITs, considered by some as the most economically sensitive of all REIT property sectors, are tightening their belts in preparation for lean months ahead. "Lodging REITs are contemplating, preparing for, and feeling the effects of a weaker economy more than other sectors," says Nap Overton, a senior securities analyst with Morgan Keegan. "Lodging companies are pulling out their contingency plans from 2002 and 2003 for saving money in ways that will impact guests as little as possible."

Sector Stats
# of REITs	10
Industry Market Cap (in thousands)	$13,309,633
% of Industry	4.7%
Yield	9.41%
YTD Total Return	-27.21%
One-Year Return	-40.417%
Three-Year Return	-10.14%
Five-Year Return	5.51%
Average Monthly Trading Volume (Shares)	2,115,776
Source: NAREIT data as of Aug. 1, 2008

By mid-summer, lodging REITs were "hoping for the best and preparing for the worst," he says. Other analysts share Overton's bleak expectations for the sector in the short-term, but the good news is that they also share his optimism for the longer-term outlook. "My gut feeling is that difficult trends will prevail through 2008, and by the end of 2009 we will see the light at the end of the tunnel," Overton says.

A Slippery Slope

Topping the list of those difficult trends is the slow slide in occupancy that began last November. There is no question that hotels are taking a hit as high gas prices, skyrocketing airfares and overall economic uncertainty curtail both business and leisure travel. A decline in the short-booking meeting business is already in evidence and expected to continue. However, still uncertain is the degree to which fuel prices will restrain leisure travel through the period, Overton notes.

With many corporate and leisure travelers already deciding to curtail travel home, year-over-year demand for hotel rooms across all property classes is down. "The hotel room base is growing very slowly at approximately 2 percent, but demand growth is even slower at approximately 0.5 percent to 1 percent," reports Jeff Donnelly, a senior equities analyst with Wachovia Securities. "As a result, [year-over-year] occupancy is declining by approximately 1.5 percentage points."

Heading into 2009, Donnelley forecasts continued weak demand and low occupancy rates. Although David Loeb, a senior research analyst for lodging with Robert W. Baird & Co., says he believes demand will recover slightly in 2009, "new supply will keep occupancy low," he says.

Uncertain Room Rate Growth

Analysts expect lodging REITs to finish the year with overall declines in year-over-year room rate growth and occupancy, but revenue will be up as a result of the small actual gains made in room rates this year. Nonetheless, rates probably will feel the squeeze even more in 2009.

The next few months will tell at least part of the story for next year, as corporate accounts negotiate for 2009 rooms and rates. "Rate growth is still positive, but we are seeing less and less ability to raise prices, and we will see more negotiated corporate rates," Loeb says. "Corporate customers will be able to negotiate a lower level, and there will be more pressure on rate growth into 2009." He does anticipate, however, that rate growth will be positive enough to offset occupancy declines by approximately 1 percent next year.

"A 2 percent to 3 percent increase in rates for 2009 over 2008 would be received well," Donnelly says. "But the leverage is now in the buyers' court."

There are universal concerns among REIT analysts that the lower occupancies expected in 2009, and the resulting pressure on pricing, will keep RevPAR growth to a minimum next year. "You take relatively weak demand for 2009, supply growth of 2 percent to 3 percent and a buyers' market, and it adds up to weak RevPAR growth next year," says John Arabia, managing director, Green Street Advisors. He estimates RevPAR growth will be 2 percent for 2008 and flat in 2009, holding EBITDA steady.

Donnelly is more optimistic than Arabia, forecasting a 3 percent increase in RevPAR for 2008. For 2009, he anticipates rate growth of 2 percent, leading to as much as 2 percent growth in RevPAR next year.

Full-service properties will feel the most rate and supply pressure in 2009. High-end properties have a more volatile cash flow in a downturn, and their margin tends to be more impacted by declines in business travel and occupancies in "fly-to markets." Also hard hit will be companies with highly leveraged balance sheets and upscale, limited service properties in suburban areas, Loeb suggests.

A Trickling Pipeline

Complicating the lodging sector's situation will be new supply coming online this year and into 2009, as projects that were started before the onset of the credit crunch reach completion.

According to Overton, supply growth in a slow economy is generally zero to 0.5 percent. Four percent is considered "rampant growth." Fortunately, given present circumstances, high construction costs and land prices have kept new project development to a manageable level, he says. "For 2008, supply growth will be approximately 2 percent and two percent again in 2009, based on projects that have been started."

Loeb pegs supply growth somewhat lower for 2008 at 1 percent, and he projects 2 percent to 2.5 percent supply growth in 2009. "This is average, but it is ill-timed," he says. Most of the new supply for the balance of this year will be in the upscale and mid-scale, limited-service categories. Although a notable number of luxury projects are under development, they are not scheduled for completion until 2009 and later because of their lengthy construction time.

The scene will shift dramatically by early 2010, ushering in an upturn for the sector. "Supply growth by then will be way down because CMBS has evaporated," Overton says. "That bodes well for 2010 and beyond."

Donnelley shares Overton's enthusiasm for the long-term outlook. "There is no financing for projects to be delivered in 2010 and beyond," he says. "Supply growth then will be low, and hotel stocks will do well."

2003 Rewind?

Although there has been some comparison of the current situation in the lodging industry to the 2002 to 2003 industry recession, Arabia is quick to point out the differences between the two scenarios. "In 2003, EBITDA declined for upper-level hotels by 40 percent to 45 percent," he says. "This trough simply does not have the same characteristics as then."

This time around, he says, the recession is consumer-led, not business-led as it was in 2003. Plus, inbound international travel to the United States, which virtually evaporated in 2002 and 2003, is strong and hotels have recaptured their pricing power from the travel intermediaries.

"The modest downturns in RevPAR and NOI we will see for 2008 and 2009 are much more typical than that 45 percent loss," he says. "The industry will struggle, but it is not as bad as last time, except for those companies with highly leveraged balance sheets."

Historically, economic slowdowns or recessions persist in the United States for approximately 12 to 18 months. Assuming that the current economic downturn started approximately six months ago, and that hotel fundamentals lag the economy by four to six months, the next 18 months will be a significant period for the lodging industry.

"Lodging REITs still have a difficult time to go through before they get to the positive," Donnelly says. "The next 12 to 18 months will not be a cakewalk."