Specifically, Fitch said it believes the rebound of business travel demand, which began in 2004, will continue to drive room rate increases and bolster already strong occupancy gains fueled by the return of leisure travelers.
"This strong demand scenario, combined with low supply growth should translate into steady bottom-line improvement and positive free cash flow over the next several years, allowing companies to restore their balance sheets to pre-recession levels," the rating agency said.
"Rising international travel to the U.S., aided by favorable exchange rates, should also continue to benefit the overall industry," the rating agency said.
Fitch said key credit risks include a slower-than-expected recovery in business travel demand, continued expense pressures that could slow expected economy-driven margin enhancement, and rising interest rates, which may affect cash flow and property resale values.
Longer term, increasing competition for franchise and management contracts could spell escalating off-balance sheet obligations and possible saturation of the domestic market, as leading operators expand their exposure to this income stream.
In addition, Fitch said it believes that renewed interest in hotel investment in recent quarters could accelerate supply growth over the next few years, particularly for the limited service segment, which has shorter construction lead times.
"The primary factors supporting improved lodging industry credit quality include better access to capital and reduced leverage," the rat8ing agency said.
Fitch said it expects credit improvement for the lodging companies in its universe to largely be dictated by the future capital allocation strategies of management. Cash flow deployment and management's appetite for leverage will be key to this process, Fitch said.
Among the largest U.S. hotel operators, financial strategies differ despite similar property portfolios and ownership profiles.
For example, Fitch recently upgraded Hilton Hotels to an investment-grade rating of BBB minus from BB plus in advance of Starwood Hotels due to increasingly divergent capital structure policies.
Improving corporate travel demand in 2004 and limited new supply has set the stage for strong fundamentals and improving profitability in the lodging sector in 2005 and beyond.
According to Smith Travel Research, industry demand, or room nights sold, increased 4.8 percent year-to-date through September, outpacing industry supply growth of 1.1 percent over the same period last year.
Revenue per available room grew 7.5 percent, driven by improvements in both average daily rate which rose 3.7 percent and occupancy, which rose 3.6 percent, over that of the prior year period.
More recently, revenue per available room growth has been even stronger, with double digit increases in six of the past eight weeks.
Strong revenue per available room growth in 2004 reflects rebounding demand from the higher rated business traveler that bolsters continued strength of the leisure traveler.
Fitch said, "Companies with exposure to major urban markets and/or an upscale concentration are especially well positioned to raise rates as the business traveler segment comes into full swing."
The rating agency said the positive outlook for the lodging sector is also supported by improving industry access to capital.
"Since the latter half of 2003, both lenders and investors have demonstrated increasing interest in the industry due to improving operating margins and greater cash flow. Bank line renewals, previously affected by financial covenant restraints, are now more accessible. Loan spreads have tightened for those companies with good occupancy in strong markets. Lodging companies also have more choices in their access to capital," Fitch said.
Hotel property sales have been well received, demonstrated by major property sales by MeriStar Hospitality Corp. and Felcor Lodging Trust Inc. Lodging stocks are also performing well, providing companies with access to the equity markets.
Based on these factors, Fitch said it expects positive ratings actions to largely outpace negative movements in 2005. Credit ratios remain above pre-recession levels for the industry; however, Fitch is optimistic that as steadily improving corporate demand drives room rates higher, profitability will continue to be restored, and property sale multiples will widen, allowing companies to restore balance sheets.
"For the most part, the sector has balanced redeployment of capital between internal expansion projects, acquisitions, debt repayment, and stock repurchases. However, Fitch expects the capital structure priorities of management will likely be an overriding factor in rating decisions over the intermediate term," Fitch said.