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In hotels, operators have an edge over owners

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Heading into an economic downturn, hotels are often among the first industries to suffer as travel slows and room rates weaken. And now, vacancies are on the rise just as the fruit of a hotel-construction boom is set to add a quarter of a million new rooms to the U.S. supply over the next 24 months.

For investors trying to determine which hotel companies are best positioned to ride out a downturn, economic and construction data don't tell the whole story. The industry has evolved over the past decade into two groups. One is composed of companies that manage and operate hotels, such as InterContinental Hotels Group PLC (NYSE: IHG), Starwood Hotels & Resorts Worldwide Inc., and Wyndham Hotels & Resorts LLC, a unit of Wyndham Worldwide Corp. (NYSE: WYN). The other group is composed of real-estate investment trusts that build, buy and own hotel properties; most REITs aren't household names.

"The companies that historically are less real-estate-intensive have generally performed better during a recession," says J.P. Morgan Chase & Co. (NYSE: JPM) analyst C. Patrick Scholes. That is partly because hotel operators have lower leverage and higher margins. Moving forward, some operators may even profit from the impending oversupply of hotel rooms by garnering management fees from the larger number of rooms. Operators also have broader exposure to international markets.

InterContinental, which besides its namesake owns brands such as Holiday Inn and Crowne Plaza, is signing up two new hotels a day that will in the future carry its brand. It is the largest hotel company by rooms, with 585,000 under its brands. Much of the growth will come in India and China.

Leslie McGibbon, senior vice president at InterContinental, says the United Kingdom company takes a 5 percent to 6 percent franchise fee on room revenue, before the local owner has to pay for expenses such as maid service, laundry and electricity. "As long as you can add the amount of rooms, even if overall revenues don't increase, you still grow," he says. In return for the fees, hotel owners get the benefit of the operators' brand recognition, reservation systems, advertising and marketing spending.

Many investors aren't convinced and are punishing both sides of the business. As of Monday, the total return for the 12 hotel REITs tracked by SNL Financial, a financial-research firm, was down 28 percent compared with a year ago. During the same period, an index of hotel-operating companies, such as Marriott International Inc. (NYSE: MAR) and Starwood, is down 15 percent. Both sectors are hovering around break-even this year.

A few savvy investors are starting to pick over the industry and have decided the biggest operators are good buys. In February, an investment arm of real-estate magnate Sam Zell said it scooped up nearly 8 percent of Starwood's shares. At a real-estate conference earlier this month, Zell explained his play: "Cheap is cheap, and I tend to get very motivated by cheap."

Lodging analyst Smedes Rose at Keefe, Bruyette & Woods Inc. sees opportunities for longer-term investors in real-estate-light operators such as Marriott and Starwood. He estimates Marriott, for instance, is trading at 17 times its expected earnings per share this year. It traded as high as 30 times a year ago and on average trades 21 times. (The firm expects to do investment-banking business with several hotel companies.)

The split in the hotel industry between owners and managers dates to the decision in 1993 by Marriott to spin off its debt-laden real-estate assets into what is now Host Hotels (NYSE: HST). Nearly all other publicly traded hotel companies have followed suit. InterContinental went from owning 230 properties in 2003 to owning 18 today. Starwood, which operates hotels under the Westin, Sheraton and W brands, owns 74 of its 900 hotels. It sold 51 in 2006 and 2007 for $4.6 billion.

The hotel operators praise their low-leverage business model that relies on charging management or franchise fees based on top-line revenue of a given hotel. "We generate our revenues off the top line of the hotel as opposed to taking something off the bottom line," says Stephen Holmes, chief executive of Wyndham, which typically takes as much as 8 percent of a hotel's revenue in a franchise agreement, even if a hotel itself fails to turn a profit.

The owners of the hotels, meanwhile, carry the burden of paying for staff, energy costs and other expenses. And as owners, they are responsible for capital-intensive outlays such as development costs and renovations. Sheraton, for instance, announced a $4 billion makeover and building plan -- funded by its owners. InterContinental's Holiday Inn brand launched a $1 billion plan to rejuvenate its musty reputation. The hotel owners will carry the weight.

Indeed, DiamondRock Hospitality Co. (NYSE: DRH), a Bethesda, Md., hotel REIT, lowered its revenue outlook for the year Tuesday, saying in a statement that "room demand in several of our key markets will be lower than our initial expectations."

The hotel REITs don't subscribe to the notion that they are worse off, especially compared with past economic cycles.

"We are in far better shape as an industry than in the prior cycle," says Jon Bortz, chief executive of LaSalle Hotels (NYSE: LHO), a hotel REIT that owns hotels in urban downtowns and resorts. Several weaker players were taken out by private-equity firms. His company has learned to cut costs faster in the downturn. And LaSalle's properties, in markets with high barriers to entry such as New York and San Francisco, will benefit in an upturn thanks to limited new competition.

Still, REITs have more potential for problems during a downturn because of their structure, which requires them by law to pay out most of their profit as dividends. "Operators have less volatile cash flow than the owners do," says John Arabia, a hotel analyst for Green Street Advisors Inc., a Newport Beach, Calif., research and trading house.

That makes it difficult, especially for debt-heavy REITs. In the last downturn, in 2001, most lodging REITs were forced to cut their dividends. Some put off critical hotel renovations that depressed business when the turnaround started. Several hotel REITs that didn't exist during the last recession have high debt loads. Ashford Hospitality Trust Inc. (NYSE: AHT), for instance, has a long-term debt to total market capitalization ratio of 72 percent, according to BMO Capital. The more-experienced hotel REITs carry lower debt ratios. Host is at 37 percent; LaSalle at 36 percent.

Perhaps the biggest edge that operating companies have over owners is that they can more easily expand their exposure to foreign markets. Starwood derives around 40 percent of its fee revenue abroad. Marriott gains around 20 percent abroad and it was a big part of its profit in the first quarter.

The REITs, because their tax structure is unique to the United States, tend to stay homebound. That is starting to change, but slowly. Host Hotels has a joint venture in Europe and announced it will enter a Singapore-based joint venture to invest in up to $2 billion worth of hotels in Asia.

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