Sign of the Times:

Investors are demonstrating confidence that the hotel sector is rebounding at midyear, shelling out large sums for marquee properties from Manhattan to Atlanta to San Francisco.

Analysts believe the lodging market is entering one of those rare moments of equilibrium where both buyer and seller enjoy opportunities. The uptick in sales is occurring after the hospitality sector, hit by dramatic declines in revenue per available room (RevPAR), saw property sale prices crater like no other commercial property category.

But now RevPAR declines are waning and hotel prices are starting to firm up after falling as much as 50% from their 2006-07 peaks. Investors seem intent on taking advantage of bottom-of-the-cycle prices to establish a foothold in the recovering market, although most properties are trading well below replacement costs and historical valuations.

Sellers, meanwhile, are cashing in on the dearth of quality product on the market, improved borrowing conditions and the willingness of buyers to accept lower initial yields.

So far, most of the recent hotel sales activity is concentrated in high-quality assets in prime markets, according to preliminary sales comparables and other data tracked by CoStar Group. At least $2.59 billion in hotel properties traded hands in 236 transactions in the first six months, compared with $1.82 billion in 231 deals during the same period last year. Hotel sales, as a percentage of investment volume in the overall CRE property sector, has increased from less than 8% at the peak of the market to more than 10% this year.

However, many of those deals involve distressed properties. More than one-third of hotel transactions that closed through June 30 involved distress conditions, such as foreclosure or deed in lieu, real-estate owned (REO), auction or short sales. And analysts say banks are more willing to unload troubled hotel assets, which are more expensive to maintain on their balance sheets than offices or apartments, which may result in an even greater pace of sales in the second half of this year.

There were 142 non-distressed transactions in the first six months of 2010 totaling $1.3 billion in dollar volume, compared to 156 non-distressed assets trading for $782 million during the first half of 2009. Meanwhile, $1.29 billion in distressed properties sold in first half on 94 deals, compared with $1.04 billion in first-half 2009 on 75 transactions.

"The numbers show the level of distress is extremely high in terms of the number of transactions, and that's not surprising," said Jeff Myers, real estate economist and hotel specialist for CoStar Group. "But you're also starting to see the higher value, more desirable properties being traded in New York, Washington, D.C., San Francisco and other markets. There's been a lot of interest in hotels as an opportunistic play lately."

"You're not going to get a cheap price-per-key like you would in ‘No Place, Texas,' but it's a good time to pick those up if you have a motivated seller."

The hotel market is experiencing some of the same bifurcation between trophy and troubled properties seen in the office and apartment sectors, Myers said. But he expects distress sales will likely continue to rise as a percentage of all hotel sales through the rest of the year.

"We recently sold a resort in Napa [Calif.] and 70% of their business was group business and corporate incentive. They really got kicked the last couple of years; the business just kind of went away," said Robert Eaton, executive managing director, U.S. Hotel Practice, for Colliers International's PKF Capital. "The high-end corporate outings that were availing themselves of the Four Seasons and Ritz Carltons and the luxury tier have had to undergo a restructuring. Those properties were hit so hard on a mark-to-market basis and the values dropped so precipitously that investors are able to buy them on an amount-per-pound basis. I don't think buyers are underwriting them on any current income, they're underwriting on replacement cost."

The buyers include REITs, pensions, private equity funds and sovereign wealth funds. Publicly traded lodging companies have reported an acceleration of business travel in May and June, increased group bookings and growing strength in vacation travel, and many are positioned to beat initial second-quarter Wall Street estimates, according to analyst reports.

Citigroup analyst Joshua Attie noted that private hotel transactions have recently accelerated and the momentum is likely to continue into 2011, with sellers eager to recycle capital after two years of abnormally low deal volume.

Bidding on high-quality hotel assets is increasingly competitive due to the limited number of such hotels on the market and the weight of equity capital on the sidelines, resulting in a "significant pent-up demand for hotel acquisitions," according to a report by a team headed by Arthur Adler, managing director and CEO-Americas of Jones Lang LaSalle Hotels. The capital includes new hotel opportunity funds and several new REITs have been formed, including Pebblebrook, Chesapeake, Chatham, which have already announced a number of acquisitions.

The rush by potential buyers ready to accept low going-in yields has created a "synthetic seller's market," according to JLL. On transactions that Jones Lang LaSalle Hotels has recently put on the market, bidders have responded with between 10 and 30 first round bids, and second or final-round bids have generally been 10-20% higher than first-round bids. Three years ago, second or final round bids in deals arranged by JLL were about 5% higher.

Meanwhile hotel owners seeking to raise capital and increase liquidity are expected to take advantage of the heightened competition among bidders to evaluate the selective sale of their non-core assets, the JLL report said.

Over the next six to 12 months, there will continue to be a limited-but-growing stock of quality assets brought to market. The advantage of sellers may erode as special servicers, banks and other sellers bring more distressed hotel assets to market, JLL said.

Capitalization rates have begun compressing for deals involving high-quality assets, reflecting a scarcity premium for higher-quality assets and buyer expectation that fundamentals will continue to improve. Rather than looking strictly at ‘going in' cap rates, buyers are looking more at such metrics as price per key, discount to replacement cost, five- to seven-year initial rates of return and yield on stabilized income in order to value the assets, JLL said.

"Because the luxury section of the market took such a hit on RevPAR, it's likely if we see any kind of economic growth, we'll see a nice uptick in those assets," PKF's Eaton said. "The general philosophy is, 'if I can buy an asset in a reasonably historically strong market at well below replacement cost, I'll be able to get out of the asset some day and presumably not lose money.'"

On the distressed property front, banks find it more difficult to hold hotels, which are more expensive to operate, and will likely unload troubled hotel assets as investor interest in the class rises and banks continue to repair their bottom lines, CoStar's Myers added.

This year's positive hotel demand may bode well for next year's office market. While the year-over-year change of room rates is still in the red, the pace of its decline is slowing markedly, according to CoStar senior quantitative analyst Omena Ubogu. Demand for hotels has led that for offices by two quarters with a relatively tight 0.72 correlation over the past 20 years, Ubogu said.

Corporate travel accounts for a significant portion of hotel demand. Companies cut back on staff, space and travel during recessions. When business conditions improve tend to send more people on the road, thus hotels can be viewed as a leading indicator of office market trends and they are sending positive signals.

CoStar deal activity shows a variety of high-end hotel properties trading in recent weeks, several of them under distressed circumstances:

• Danske Bank sold the historic Knickerbocker Hotel in New York City in a distress sale to Highgate Holdings, in partnership with Ashkenazy Acquisition Corp. and Crown Acquisitions. The joint venture purchased the landmark building, built by legendary businessman John Jacob Astor IV in 1906, for $180.5 million. The 16-story, 300,000-square-foot building, now known as 6 Times Square, is located at 1466 Broadway in the Penn Plaza/Garment District. Danske Bank took over the property in March after owner Istithmar World Capital, a branch of Dubai World, defaulted on its $300 million mortgage.
  
• Maryland-based DiamondRock Hospitality Co. acquired The Hilton Minneapolis from joint venture for $155.5 million, or nearly $190,000 per room. The 25-story, 821-room hotel at 1001 Marquette Ave., built in 1991, is the largest hotel in Minnesota. "The hotel was purchased on accretive metrics and is expected to achieve strong growth potential," said Mark W. Brugger, CEO of DiamondRock Hospitality.
  
• Chesapeake Lodging Trust agreed to purchase the 430-room Boston Marriott Newton in Newton, MA, for $77.25 million, or about $180,000 per room, in a deal set to close by the beginning of next month. The 560,777-square-foot hotel is about 10 miles west of Boston in Middlesex County. The Procaccianti Group acquired the Marriott from Host Hotels & Resorts Inc. in June of last year for $29 million, or about $67,442 per room. "RevPAR in the greater Boston market is up 13.3% year-to-date through May 2010," said James L. Francis, president and CEO of Chesapeake. Annapolis-based Chesapeake, which went public in January, also recently closed its $46 million purchase of the 188-room Hilton Checkers Los Angeles hotel.
  
  
• InterContinental Hotels Group sold its 422-room, 21-story InterContinental Buckhead Atlanta property to Pebblebrook Hotel Trust for $105 million, or about $248,815 per room. Pebblebrook, a Bethesda, MD-based hotel REIT, funded the purchase with cash from its December IPO. Pebblebrook bought the hotel in the Upper Buckhead submarket with plans to invest $7 million in capital improvements to guestrooms, meeting space and public areas. While the Buckhead hotel market, like the national hotel market, has been significantly impacted by the economic downturn, hotel supply remains more constrained than Atlanta as a whole.
  
• Pebblebrook, looking to acquire other upper-upscale properties in the nation's 20 largest markets, also entered into an agreement in late May to purchase the Sir Francis Drake Hotel at 450 Powell St. in San Francisco , CA, from Chartres Lodging Group for $90 million. The 23-story, 416-room Sir Francis built in 1930 is burdened by a $37.45 million debt maturing in July. The loan securitized through Credit Suisse First Boston Mortgage Securities was transferred to special servicer Wachovia Bank.
  
• Starwood Hotels said in April that it has completed the sale of two Midtown Manhattan hotels. St. Giles Hotels has purchased the W New York - The Court and W New York - Tuscany for $78 million, or $243,750 per room. Located on 39th Street near Lexington Avenue, they were among the first properties to be operated under the W banner.