veryone who gets involved in a real estate venture asks anyone within ear reach the following question: "what are the three most important elements for success in developing a piece of real estate?". Almost without fail the person questioned raises an eyebrow and states dogmatically that there is only one axiom in investment and that is 'location', 'location', 'location'. And with that the questioner is to rest assured that they have all they need to proceed without caution in faith that they cannot fail. In the age of the internet, if nothing else has been proven, it is that that old axiom has lost is hallowed position as the ultimate answer. People originally officed themselves in London, New York, San Francisco to be where the money is so that they could be successful in their ventures. Now, some of the most powerful people in the United States are located in Seattle, Washington, Telluride, Colorado, Omaha, Nebraska and places equally inconsistently with the philosophy of having to be near the money sources in order to make money.

Upon recognizing that most of the old axioms have died a morbid death, perhaps it is time to try and ascertain if there are any new truths to which one may hand their hat in order to be successful in the development game. So we will embark for a brief moment on a quest somewhat similar to the age- old question of which came first; the chicken or the egg. Is development now into the "Field of Dreams" era, where if you build it they will come, or do we have age old axioms to rely upon. Ergo, the question at hand is to determine whether necessity, i.e. the demand side of the demand vs. supply dynamic, or a capitalization rate, i.e. the financiers magic wand, is the major driving force in development in todays economy.

Twenty years ago it would be easy to answer these questions. Things had been very steady in the development world regarding office buildings, apartment buildings, shopping malls, and even hotels. There was limited capital, and the capital was used to meet pent-up demands by the wise investor. The wise investor often desired to be the 'third' owner of a project, becuase that was where the profit was to be found. For purposes of this study, we will not even begin to try and understand the economics associated with the office building world, where the micro-chip has relegated the need for document storage back to the hula hoop, and apartment buildings to the 'singles only', 'seniors only', age of segmentation. We will take on an even more nebulous investment vehicle, the hotel.

Today we have supply side economics running rampant throughout the world. One only has to look as far as Orlando, Florida, Las Vegas, Nevada or the Red Sea of Egypt to see that all of the demand indicators be damned, full spead ahead on adding hotel rooms.

In order to do justice to the question at hand, we need to go back and study our industry's history to get a common basis for judgment. History would have it that the hotel industry can trace its beginnings to the old tavern. When the country squire decided to make a meeting with his good friend from across the county, he would send a messenger to invite him to meet at a place easily recognized. Typically, this would be a tavern half-way between the two gentlemen's residences, located at an intersection of their under-paved roadway system. Then, because of the vagaries of travel on horse-back, (weather, thrown horse-shoes etc...) things would transpire to have one or the other would be late. So the tavern owner was faced with an increasing number of strangers sitting at his establishment waiting for a business associate to arrive and literally no place to put them, other than in his apartment on top of the tavern. The wise entrepenurially directed tavern owner decides to start renting out these rooms for a fee, and like everyone else in the hospitality business determines that the highest return on your invested dollar is in a hotel room because it has the lowest on-going expense attached to it. We still have this phenomenon in England, where you have 35 room Inn's with 2 million pounds in revenue, and 3 restaurants in the same building doing 4 million pounds in revenue. With the high costs of labor in the United States, the trend very quickly went to 70 rooms and one restaurant, and now it is 150 rooms and no restaurant, but we are getting ahead of ourselves. Not unlike the technilogical explosion of the 20th Century, from the earliest times to the middle of the 20th Century, not much changed in the hospitality area. For over 1000 years, the hospitality industry was driven by the Owner-operator, who typically interned his children in the business and handed down the time-worn operational truths from father to son. Then with the end of the Korean conflict, led by a contractor from Memphis, Tennessee named Kemmons Wilson, who having fallen in love with a movie starring Bing Crosby created through Holiday Inn a sub-industry known as hotel franchising.

For the next 25 years the hotel industry was driven by developers and franchisors. Fueled by the frenzy known as Tax Shelter investing from 1974 through 1986 the industry was actually driven by tax shelter developers. Unfortunately, during this time there was a complete disregard for the actual profitability factor in the hotel. So long as the investors, wealthy doctors, wall street investors, highly compensated executives, consummed with avoiding, defering or delaying their annual tax payments, were receiving 8 to 1 tax deductions for real estate investments in hotels then there was no need to be concerned with issues as mundane as fiscal responsibility. Coupled with the Savings and Loan industry's scandalous lending practices and the irresponsible panhandling of feasibility studies by former Big Eight accounting firms the hotel industry build properties beyond it's capacity to fill with room users. The tax reform act of 1986 brought almost all of these investment strategies to a halt. Between the impact of the gasoline bust cycle in the West and the Savings and Loan lending crisis, the hotel industry absolutely crashed and burned. During the calendar year 1989 it has been reported that less than 10% of the hotel's made its debt service on a current basis. During the calendar year 1990, the operating profit for the hotel industry nationwide stood at a minus 6 Billion Dollars, at the Gross Operating Profit line. That means before taking into consideration the cost of real estate taxes, insurance, management fees, AND debt service the approximately 40,000 hotels open in the United States were losing an average of ONE HUNDRED FIFTY THOUSAND DOLLARS EACH!!! For comparisons sake in 1998 the approximately 48,000 hotels operating in the United States had a profit at the Gross Operating Profit line of 18 Billion dollars, or Three Hundred Seventy Five Thousand Dollars to pay toward their capital formation, real estate taxes, insurance and management fees.

Back to our chronology. If the era from 1974 to 1986 was driven by tax shelter developers, the era from 1986 to 1994 was driven by the lending institution's asset managers. While at first glance this would seem to be a solid group of people to rely upon for sage decisions, nothing could be farther from the truth. (The reason for this is that in fact the original asset managers were the poor smucks who made the original bad loan to begin with; not exactly someone armed with extension knowledge in hotels once could guess! Later the surviving lending institutions hired hotel experts as asset managers, but it was too little and way, way, way, too late) What is a truth is that these asset managers were ill equippped to take on the responsibility of making decisions regarding the management of hotels because of the great difficulty inherent in managing a hotel. While hotels serve to be a wonderful 'hedge against inflation' (a concept developed in greater detail later) there are a very complicated business to run, fraught with pitfalls because there is a staffing requirement for minimum service levels that an operator cannot afford to breach. You can in the short term reduce your service levels to save money, but the impact shows up 6 months later, and it takes a yaer to overcome the mistake. The short term savings take years to recover in profit. Well, these bankers/asset managers didn't understand this very basic requirement, and the result was chaos for the industry. Let me share a short story with you to prove this point. While many people suggested that the cause of the severe downturn in the hotel industry was the overbuilding of the 1983 to 1986 period, my thesis is that the problem was indiscriminate price cutting. The cause of the price-cutting is manifest in the moral of this story.

There once was a Savings and Loan Association headquartered in a very large Mid-western town, not St. Louis MO. I say once, because it is no longer. This S&L was the single largest S&L lendor in the hospitality industry, having at one time over 160 loans on hotels throughout the United States. There were four divisions supporting the home office, located in various money centers. Because of the de-centralized nature of their business activities, and their single-minded focus on earning fees for originating loans, this was a classic case of the right hand having no idea what the left hand was doing. Suffice it to say that there is an intersection in Cleveland, OH, where there was a Holiday Inn, located on the northeast corner of the intersection, a Days Inn located on the southwest corner of the intersection and a Ramada Inn located on the northwest corner of the intersection. Unfortunately for these owners, they had all contracted with the same former Big Eight Accounting firm for a feasibility study. The feasibility study, while excellent for the Holiday Inn which was the first property built at this intersection, was not modified by the accounting firm to take into consideration the additional rooms at the intersection. In other words, when the Ramada Inn was built the exact same, almost identical feasibility study was used, and even though the accounting firm should have taken into consideration the to be opened competition at the intersection it did not. The result is that the underwriting was seriously flawed by the lending institutions because they had every reason to believe that the future forecasts were accurate.

These forecasts would have been accurate had they taken into consideration the competing rooms, but because they didn't all three properties were under-performing expectations. The first property to fail to meet its monthly cash flow was the third property opened. The reason for this was that it had the highest leverage and was a johnny-come-lately to the marketplace, after the competition had sewn up what contract business was available. The ownership has a non-recourse loan, and seeing the hand-writing on the wall, handed the keys back with a deed-in-lieu so that they could afford to keep their credit rating looking good, and save the lendor the expense of a costly foreclosure. Enter stage right the bank loan officer who made the ill-fated loan who was now cast in the role of hotel manager, having just kept the General Manager in place, because why incur the cost of a management company, running a hotel can only be just so tough. This ego, while perhaps earned by a doctor who thinks he can do anything better than anybody because he is so bright was ill-fitted to the loan officer. His first action was to advise the General Manager to lower the rates by 30% so that he could increase the occupancy immediately and then find a buyer quickly who would pay to take over the loan, believing that any good manager could increase the rates, what with the high occupancy. The problem was that any buyer was knowledgeable about hotels, and realized the artifically low rates were the only reason the occupancy spiked so quickly. A rate war ensued. Each property on each quadrant lowered their rates to combat the lowered rates across the street.

After nine months of lower than reasonable rates the loan officer was confronted with the results of his misplaced expertise in the hotel industry. The property across the street, which had been doing wonderfully before the competition had lowered the rates so dramatically, was also financed by the same Mid-west based S&L, and now the S&L had two REO (a term meaning that the lendor has Real Estate Owned assets) properties, across the street from each other. Of course, our genius loan officer/hotel asset manager had no idea that one of the properties across the street was also financed by the company which paid his salary.

What had in actuality occurred from 1986 to 1989 was a 4 point drop in occupancy nationwide; from 65% to 61%. But between 1984 and 1991 there was a 40% drop in average daily rates (in 1984 dollars) while at the same time the fixed expenses at the hotels were rising by 14%. The gargantuan profits achieved in 1998 were achieved in a nationwide occupancy of 63%. The difference therefore was not a function of occupancy but of average daily rate. During this period of having the Lending Institutions driving the industry, less than 10,000 new hotel rooms were developed. Since the average was 50,000 rooms per year, to have this in 5 years tells the story; this is akin to no development whatsoever!!

During the early 1990's there were tremendous efforts being made by our Federal Government to pull the national economy out of the S&L disaster. The Resolution Trust Corporation was formed to take all of these assets out of the hands of the Federal Deposit Insurance Corp, which as the ultimate beneficiary of all of these bank and savings and loan failings and place these assets back in to the hands of the private sector. For the hotel element to these assets, major auction sales were held with hundreds of hotels being made available to the marketplace within an 18 month period. The rush to develop these assets coincided with the resurgence in the American economy, and voila, we had a large upturn in the profitability of hotels. But with so many hotels, and so little capital from banks, savings and loans, and insurance companies, none of which would make a hotel loan for love or money, where was the savior?

Enter Wall Street to the list of driving forces for the hotel industry. Beginning with what was commonly referred to as the 'hill-billy' REIT, more affectionately known as the RFS REIT, the hospitality industry found its way out through the economic blessings of Wall Street. Either through providing funds for securitized loans, or through the creation of money for the Real Estate Investment Trusts (REIT), Wall Street produced billions of dollars to allow for the acquisiton and renovation of a great number of the hotel assets available for acquisition. Patriot American and Starwood became industry leaders in 1996, and neither company existed in its present form in 1993. Going from a start-up company to a multi-billion dollar company in three years made even the later to arrive internet stocks look tame. Up until August of 1997 when Wall Street became disenchanted with the hotel industry and immediately cut off the funds because of fears of rampant over-building the hotel industry was Wall Street driven.

And as with most issues in life, we have come full circle. Now that the industry has stabilized, prices are no longer crazed because of the bidding wars between the REIT's for the premier properties, the Operator is back driving the industry. As many of the public companies look to go private to eliminate the large cost of being a public company with no advantage since there are no large secondary placements on the horizon, the Operators are back making the machine run. The investors now must look to his operator to validate the true potential for his acquisition target.

Armed with our history lesson, let us return to the topic at hand. What is the answer to our question? Is it necessity or the underwriting criteria which is the mother of development.

Time Period Mother of Development

First Thousand Years:Necessity (Demand based) Franchisor boom:Necessity Tax Shelter:Capitalization (Underwriting based) Lendor REO:Neither: (no hotels developed) Wall Street:Capitalization (the only thing Wall Street understands)

After having seen the age of development being driven by a need to grow a franchise; by a need to make a good tax defering investment; a need to retake and reposition a bad loan; a need to put Wall Streets money to work; the hotel industry is back to the basics. Necessity and

Capitalization Rates are now equally important. While the industry was in the hands of the lendors, they became much more sophisticated and understand the industry much better than they did during the 80's. Because of pioneers like Randy Smith with his STR reports the lendors now have ready access to supporting information without having to seek out consultants. The underwriting criteria for loans has become a capitilization rate format, but the market information available enables the decision make to balance the demand factor with the underwriting probabilities to a higher degree than ever before in the history of the industry. And it is the hope of everyone in the industry that this new found balance leads to intelligent development based on both the capitilization rate and the demand factors meeting in harmony to insure that demands are met within a comfortable frame-work of necessity.

GREAT QUESTIONS:

What is the biggest threat confronting the hotel industry going into the New Millennium?

It's a five letter word called "LABOR". Or if you want the long version, labor shortage. With the U.S. unemployment at 4.2%, knowing of course that all economists preach that unemployment under 6% is an unbalanced economy, there is tremendous pressure on the hotels to maintain proper service levels. Since hotels have traditionally been an entry type of job for the less skilled, we are faced with the difficult problem of dealing with a labor market that has shrunk, so that positions are being filled requiring skills with unskilled people, leaving the unskilled positions with few candidates.

What issues are a direct result of this labor problem?

We as an industry are having jobs filled with people who not only do not speak English as a second language, they are not really truly conversant in their mother language. Or we are dealing with people who have such serious personal issues that they are finding coming to work on any level as taxing. The new rules for welfare receipients have forced many such candidates into the work-place, but the issues of health-care, day-care, are placing demands on the hotels which never occurred historically.

Diversity is not a problem in itself, but it becomes a problem when you have such difficult language issues. We as American's have always had a rather large ego when it came to learning other languages in our schools. When you live in Europe, learning two or three languages was necessary for survival. We in America never had that incentive. So your English speaking head of housekeeping may not be bi-lingual, and as such is in a predicament when the labor force turns out people who speak 4 different languages, non of them being English. Thank goodness, the American Hotel and Motel Association has an extensive series of training tapes which are non-language tapes, so the basics can be taught without regard to language. But in order to create a true team-work environment, it is difficult with language problems throughout your department.

What is the greatest strength in the hotel industry?

As with most things in life, your greatest weakness is the flip side of your greatest strength. Just like persistence may be your greatest strength, stubborness may be your greatest weakness. Just so with hotels being challenged with the inability to attract mainstream workers, the Hotel Industry continues to be the avenue for a generation of workers to create an income so that the off-spring of those workers as second generation Americans are filling our hotel schools with candidates for executive positions.

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