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Full-Service Luxury Hotels Are Outperforming the Rest of the Hotel Sector. So Why Are Developers Not Building More of Them?

In spite of great property-level fundamentals, full-service luxury hotels come with more risk.

The hotel sector is having a great year. But full-service luxury hotels—the kind of properties in prime locations that often include conference spaces and multiple restaurants—are doing even better than the rest of the booming hotel business.

“Well-maintained, full-service hotels continue to do very well today,” says R. Mark Woodworth, senior managing director and head of lodging research for CBRE Hotels.

Rates are rising quickly for luxury hotels. That’s partly because these properties often don’t have a lot of competition. Developers are currently opening very few new hotels targeted at the top of the market.

The occupancy rate for luxury hotels averaged 74.6 percent so far in 2018. That’s significantly higher than the occupancy for the hotel sector overall, which has averaged just 66.1 percent over the same time period.

The income is also growing quickly for full-service, luxury hotels—room rates have grown by 3.5 percent and revenue per available room (RevPAR) has grown by 4.4 percent. That’s much better than the performance in the broader hotel sector, in which room rates have grown by 2.5 percent and revPAR has grown by 2.8 percent.

Few Developers Are Building Luxury Hotels

Why are luxury hotels doing so well? Part of the reason is that they don’t have to compete with many new properties. The inventory of luxury hotel rooms in the U.S. grew by just 0.9 percent in 2017, while the demand for rooms grew by 1.5 percent. The demand for rooms has continued to grow faster than the inventory so far in 2018, driving average occupancy rates higher.

“Because of the development economics, there has been very little new development of luxury hotels,” says Woodworth.

Despite solid performance, the prices that investors are typically willing to pay to buy a full-service, luxury property are still below the cost to develop the hotel. “As good a recovery as we have gone through, the market values for luxury hotels have still not caught up to replacement cost,” says Woodworth.

Luxury hotels cost more to develop partly because they often include a large amount of extra space for meeting rooms and amenities like restaurants. As a result, the amount of square footage that a developer needs to build per room is much higher for luxury hotels. Luxury hotels are also often located on expensive development sites in prime locations and decked out with costly, high-end finishes.

Meanwhile, lenders are less eager to make the giant loans necessarily to build a new luxury hotel property. “The cost to build a full-service hotel is so high. You can have one full-service hotel or six limited-service hotels,” says Jan Freitag, senior vice president with research firm STR.

In addition, these large properties can come with significant risk. Several projects to develop luxury hotels ran into problems during the financial crisis, with a few high-profile defaults.

“Lending officers in financial institutions were around in the last downturn. They have a long memory,” Freitag notes. “Scrutiny is a lot higher than it used to be.”

Lenders and investors may think of limited-service hotels as being a safer bet in case of a downturn because they are less subject to how much businesses are willing to spend on conferences and events. “What is attractive about select service is that the

revenue is more from room sales, rather than revenue from meetings,” says Kevin Mallory, global head of hotels for CBRE.

The high cost of labor hurts full-service hotels

Just like the rest of the hotel business, luxury hotels also have to balance their growing revenues against rising expenses. The cost of labor, in particular, is rising quickly—and luxury hotels are more vulnerable to rising labor costs than the rest of the industry.

“Full-service hotels have to hire more people,” says Woodworth.

The unemployment rate across the U.S. was just 3.7 percent in October. That’s the lowest the main unemployment rate has been since 1969. That represents a serious shortage of labor, in which workers have to ability to demand higher wages.

“The pressure on the cost of labor has been significant for the last three years and it is going to get worse,” Woodworth notes.

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