by Gary H. London

San Diego is leading the way in the recovery of the hotel market. In the market measurements that count — average daily rate, or ADR, and occupancy — San Diego is outperforming California and the nation.

This does not necessarily translate to “good times” yet in the hotel sector. In all likelihood this sector will take longer to recover than residential and high-quality commercial. The hotel market sits precariously at the top of the real estate pyramid. It wobbles first with the fall of the economy and is notoriously the last to recover.

Why? It’s a simple business proposition, actually. When a landlord leases commercial space the lease term is usually three to five years, with options to renew. When a landlord leases an apartment it is usually for one year. However, when a hotel management company leases a hotel room, it is usually for one to seven nights.

Hotels represent a higher level of risk than other types of real estate. Because of this, “success” in the hotel sector is measured in occupancies of 70 percent vs. 90 percent to 95 percent that is characteristic of those other real estate sectors.

San Diego compares favorably with either California as a whole or the U.S. even though ADR has adjusted slightly downward this year when compared to last year ($115 per room average vs. $123 per room average). This is not a sign of weakness. This rate is still well above the nation ($95 average ADR) and California ($95 ADR).

The hospitality industry has reset itself and adjusted to a “new normal.”

Occupancies Inch Up

The local market is performing quite a bit better than just two years ago. In fact, occupancies in those same periods were up three points, from 59 percent to 62 percent. Hotel operators are adjusting rents to gin up their occupancies. Consumers have responded with increased demand.

ADR finally stabilized in the second half of 2010, after initially experiencing a weak first half.

This show of strength has continued to 2011. Expect to see ADR again push higher throughout the remainder of this year, perhaps another 4 percent to 5 percent, according to hotel sector expert Robert Rauch.

Rauch projects occupancy to continue to march toward 70 percent at San Diego hotels, well above the rate of inflation. At that level, this hotel market will remain at the top-of-the-market compared to national averages of less than 60 percent, a place where we are traditionally positioned.

As the economy improves, so too will the hotel sector. When the economy entered its recession, much “elective” travel halted. People stopped going on vacations, business sales representatives stopped visiting their customers, and companies and industry organizations stopped having conventions.

In fact, these are the three key market segments that feed demand for hotels, and the San Diego market is very strong in all three. Gradually, each of these sectors is returning. Leisure accounts for approximately 55 percent of demand for hotel rooms in San Diego. Leisure traveler behavior is directly related to the economy. These are people on vacation who visit our beaches, SeaWorld, the Zoo and other famous tourist attractions.

Competitive Advantage

During the past three years people have been more restrictive about their vacation travel. The San Diego competitive advantage is that we are a relatively accessible, less expensive tourist destination with large nearby “feeder” markets including the remainder of Southern California and Arizona. In fact, when the hotel sector was down, such as post-9/11, we were not as “down” (or at least we recovered faster) because we became the alternative over a more exotic destination that might have required plane travel and high expenses.

The group market accounts for approximately 25 percent of hotel demand in San Diego. This is the sort of market that is driven by conventions. This portion of the market was highly impacted by the recession as companies and industry organizations cut out or cut back on the conventions. Because of the long lead times associated with these meetings, many of which are very large, we did not see much loss of this business.

Even so, while our core convention facilities perform quite well, San Diego is on a more level playing field in competing for this business as compared to other large convention cities such as Chicago, Las Vegas, New York and San Francisco, all of whom attract market share.

We also do very well in the business travel and military/government sector which accounts for about 20 percent of hotel demand. Corporations are again allowing people to travel, having witnessed the bad results of not being face-to-face with customers.

Even with this relatively good news, the market is still fidgety and results are spotty. Luxury and higher end properties are recovering faster, probably because they “tanked” earlier and further. But their percentage recovery is better.

San Diego’s downtown market is running relatively strong, as has the coast, but Mission Valley, the Interstate 15 corridor, East and South County suffered quite a bit. Rauch believes they will all come back stronger over the next five years. But in the meantime, that is a lot of operating pain.

Economic Clearance

While we have now seen some recent nondistressed transactions, there is not a lot of value in hotel assets that make them purchasing targets. Real estate investment trusts are buying, but they accept lower returns. Pricing is too expensive because few owners of hotel assets are prepared to walk away from their assets, even if the market has not yet stabilized.

This is a good sign, actually. It means that the hotel players see better times ahead.

Locally, the most prominent deal was confirmed last week when Doug Manchester sold his Manchester Grand Hyatt on the bay front in downtown for $570 million to the REIT Host Hotels & Resorts. However, most analysts would suggest that this was not exactly a “market driven” deal. At approximately $350,000 a key for the biggest convention center hotel in the city and the largest in Southern California (1,625 rooms), Host didn’t need to buy for a “home run” return. They are likely to be just fine with a low return. They are a REIT, not an opportunity fund.

There are still losers out there. They mostly include hotel properties that were built (or committed to financially) toward the tail end of the economic boom period but could not perform at “pro forma” levels, essentially the level of expectation of ever-increasing room rates and occupancies. There is an economic clearance going on with those projects — lenders taking back notes that can’t possibly be repaid, some bankruptcies, change of operators, etc.

Most of these properties are substandard. They are in marginal locations or operating at the lower end. These assets will eventually find the economic base from which they can successfully operate.

There are a handful of luxury properties which had been designed and programmed to operate at the highest end. When the luxury market slipped, operators changed, such as at the Four Seasons at Aviara. Ownership replaced Four Seasons with Park Hyatt. While the operating economics changed, it is so far mostly unnoticeable to the clientele.

Expect to see a continuation of the chess game of some properties changing ownership, operators being replaced and a general shake-up in the sector at least during the next 24 to 36 months. It is a sector that is positioning itself for better times ahead.