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The state of hotel development: it's on the decline, but that's good

Hotel development hasn't just declined — it has plunged. In the last quarter of 2000, more than 300 hotels fell out of the hotel development pipeline, according to Lodging Econometrics, the research division of Portsmouth, N.H.-based National Hotel Realty.

While that may sound dire, hotel industry observers call it a healthy development.

Lodging Econometric's numbers describe the development environment this way: In the third quarter of 2000, the active pipeline contained roughly 1,886 hotels under development. By the fourth quarter, that number had fallen to 1,575.

“That is the largest sequential decline since we've been tracking numbers,” said Bruce Ford, director of sales and marketing for Lodging Econometrics. “It's huge. And it means that lending standards have tightened and caused the development pipeline to shrink, while hotel developers have begun to think twice about projects.

“This is very healthy for the hotel industry, which has never been more profitable, never had more hotels and never been smarter,” Ford said.

But how long will development continue to sag?

Lodging Econometrics' recent report, Hotel Real Estate: First Quarter 2001 Report On the State of the Industry, predicts that the drop-off in new development will not last long and will end with a soft landing, or by bottoming out, in early 2001. The bottom, once reached, will persist for about a year, followed by a recovery somewhat less dramatic than the one that occurred in the mid- to late- 1990s.

Good news?

The decline in new development will benefit hotel owners and companies with strong brands as new room supply descends below an annual growth rate of 2.5%, which is widely considered a healthy growth rate in the industry, according to the Lodging Econometrics report.

As the national economy appears to have shifted gears to slower growth, and even toward a possible recession, the decline in development activity may restore a solid balance between supply and demand that has eluded the industry for the past couple of years.

According to the Washington, D.C.-based Hotel and Lodging Association, industry revenues surged nearly $37 billion during the 1990s, from $62.8 billion in 1990 to $99.7 billion in 1999. The last two years of the decade, 1998 and 1999, each in turn ranked as the most profitable years ever for lodging.

Despite the excellent revenue performance of 1998 and 1999, however, room-supply growth — a function of development — reached unprecedented levels in those years, according to an article in Trends and Statistics by Mark Lomanno, president of Hendersonville, Tenn.-based Smith Travel Research. As a result, Lomanno wrote, “Occupancies were declining, average room-rate growth consistently was below prior-year levels, and stock prices of public lodging companies languished.”

Then in the middle of last year, the pace of development dropped dramatically.

Virtually all industry insiders discount the macro-economy's move toward recession and focus on the benefits likely to flow from falling development numbers.

“Many economic analysts focus on the possibility of recession and how that could devastate the hotel industry,” said Stephen Rushmore, president of Mineola, N.Y.-based HVS International, a hotel valuation and consulting firm. “Historically, however, that doesn't happen,” he said. “A decline in demand caused by a recession doesn't devastate the industry. In the last 30 years, there have been only six years in which demand has declined. These were years during the major recessions of the early 1980s, middle 1970s and in the early 1990s.”

Bad as the recession of the early 1990s seemed to be, Rushmore pointed out that it produced only one year when demand for hotel rooms declined: 1991. “Demand tends to go down far less in bad years than it goes up in good years,” Rushmore said. “It's not a drop in demand that causes major problems, it is an oversupply of rooms. That's the main risk factor for the hotel industry.”

Still room for development

In all economic environments except depressions, the key to profitable new hotel investment, according to Rushmore, lies in finding development locations with barriers to entry or supply constraints, which make it difficult for competitors to build hotels nearby.

A number of U.S. markets fit that criterion today, including the Northeast, Southern California and the Mid-Atlantic. “In these markets, the cost of land is high, zoning and regulatory requirements are difficult, and building codes are more stringent,” Rushmore said. “So it's more expensive to buy land, tougher to get permitted and more difficult to pencil out a hotel. This is why we haven't seen overbuilding in areas such as Boston, California and Long Island, New York.”

On the other hand, Rushmore characterizes the markets in the Southeast and Texas as not posing particularly difficult barriers to entry. Land is easy to find and buy, and hotels are easy to put up, he said.

In fact, given the relative ease of developing in the limited-service category, Rushmore detects the potential for overbuilding in these asset types in some markets.

William Murney, a senior vice president in the hotel and leisure advisory group of El Segundo, Calif.-based CB Richard Ellis, senses an overbuilt market in the limited-service category as well.

However, he also believes that the financial markets have applied the brakes effectively. “It's been difficult to obtain development financing in these markets over the last six to 12 months,” he said. “The reasons include rising interest rates and a concern among lenders about potential overbuilding.”

Upscale developers, on the other hand, generally seek out locations characterized with barriers to entry. As a result, these developers tend to find more financing options open to them, Murney said. These options include consortium partners, opportunity funds, foreign banks and Wall Street. “Tishman [Realty Construction Co., New York], for example, is coming out of the ground with the Times Square Westin in New York City,” he said. “It took about a year to put that project's financing package together that includes a consortium of four lenders and an equity component of almost 40%.”

Rising Equity Requirements

“It's been difficult to obtain financing in these markets over the last six to 12 months. The reasons include rising interest rates and a concern among lenders about overbuilding.”

As indicated by the Times Square Westin project, equity requirements have gone up across the real estate development industry. Analysts say most hotel development deals today require an equity contribution between 35% and 40%. “If you hear that real estate equity requirements have risen, it is generally true that the equity requirements for hotel development in particular have risen the most,” said Michael Sonnabend, a managing director at AFC Realty Capital Inc., New York. “When the real estate market hiccups, the first capital market to tighten up is the hotel market, thanks to the perception of higher risk in the hotel sector.”

AFC serves as an intermediary, or broker, that provides capital for real estate transactions in all property categories. Sonnabend said business has picked up in the hotel sector for AFC. However, increased requests for broker-managed financing may provide additional clues that hotel developers are finding their traditional lenders growing edgy about the risk of hotel real estate.

That perceived risks irks some hotel executives. “I disagree with the idea that hotel investments are so risky,” said Thomas Corcoran Jr., president and CEO of Irving, Texas-based FelCor Lodging Trust. “Look at the public real estate lodging companies,” he said. “All have debt in the range of about 50%, which is lower than a lot of public real estate companies.”

He added that stock prices for many hotel companies have remained level since the beginning of the year, while the market as a whole has slipped. “To me, this means that investors view the very conservative balance sheets of these kinds of companies as a safe place to put money,” he said.

Contrarian debt providers

Despite rising equity requirements and tightening financial standards, Kyle Poole, director of Washington, D.C.-based Hotel Finance Specialists LLC, believes that the recent fall in interest rates may have begun to loosen up the lending climate, particularly among banks.

“Many lenders still feel that hotels are overbuilt, and they are still shy about lending in the category,” Poole said. “At the same time, with interest rates going down, banks have more money to lend and are more willing to lend in the hospitality sector because asset classes like hotels provide the highest return in the marketplace.”

Poole's firm represents clients such as banks and places bank loans in the hospitality sector. “We have seen some of our bank lenders reducing their rates,” he said.

Some clients of Hotel Finance Specialists have actually targeted the hotel sector. “One of our aggressive bank clients recently bought a block of money at 5% [interest] at a federal auction,” Poole said. “This client now wants to lend this money out at, say, 8.5% in the real estate sector. Looking at the real estate asset classes that offer the highest returns — and perhaps the greater risks — this bank has elected to provide financing for hospitality and raw land acquisition, and we are helping arrange the hotel loans.”

To be sure, equity requirements remain high in Poole's experience — from 30% to 40%, with lenders insisting on loan-to-cost ratios in the 60% to 70% range.

And Poole has noticed that lenders today are insisting that borrowers have management experience as well. “Several years ago, there were opportunities for first-timers, but not today,” he said.

Lenders today also will pick and choose locations in which they are willing to write loans. As a result, hotel developers will find several cities perceived as overbuilt that are virtually off limits. Poole cites Dallas and Phoenix as two examples of “blacklisted” cities.

At the same time, deep-pocket developers that have uncovered high-growth locations with strong barriers to entry may find matches with today's more selective lenders. “New England tends to have high barriers to entry,” Poole said. “Lenders seek out deals in these areas and compete for them, believing that there will be little possibility for competition for some time.”

“Many lenders still feel that hotels are overbuilt, and they are shy about lending in the category… Several years ago, there were opportunities for first-timers, but not today.”

Lenders that pick and choose

By being selective, Columbus, Ohio-based RockBridge Capital Inc. has maintained a constant flow of deals over the past three years, a period that saw the market move from lively development to today's more restrained level of activity.

RockBridge makes mezzanine loans, a category of finance that might be viewed as somewhat more risky than others. Hence, the company has adopted a highly selective approach to deal making.

Approximately 75% of the company's loans go to the hospitality sector, with a high percentage of that financing new developments.

“As the market slows and the loan-to-value ratios of first-mortgage lenders decrease, we're seeing an increased need for mezzanine capital,” said James Merkel, vice president of RockBridge.

In selecting deals, RockBridge studies Smith Travel Research reports that detail existing competitive market performance, economic trends, barriers to entry, new supply and demand generators. “We ask ourselves if we believe this new property will meet some unmet demand in the marketplace,” Merkel said. “Most importantly, we focus on the track record and integrity of the owner/operators to see how they conducted themselves during bad times.”

Next, RockBridge evaluates the distinguishing characteristics of the hotel's market. Is it a corporate market or a leisure market? How much demand for each hotel type exists in the market? Most importantly, how much of this demand is not being met by the existing supply of hotel rooms in the market?

“Certainly, the lodging business must deal with macro-economic trends, but specific markets are often insulated from these macro trends,” Merkel said. “In the end, we have found that you make good loans by choosing the right owner/operator as a partner. So we look to identify owner/operators that are patient enough to spend whatever time it takes to uncover niche opportunities.”

Such a painstaking approach to market analysis suits Rushmore of HVS. The drop in new construction has been good for the industry, he said, but it does not mean that developers must cease and desist.

“Certain markets are starting to get overbuilt, as are certain asset classes such as limited service,” Rushmore said. “But a lot of markets can still absorb new hotels. Developers today cannot look at what's happening overall in the economy. The hotel industry has had record profits for several years now, and there is no reason that will not continue.

Rushmore advised developers to analyze prospects on a market-to-market basis. If they do that, and can find a good site with barriers to entry and obtain financing for the project, his advice is simple — go for it.

Mike Fickes is a Baltimore-based writer.

Insurance company embraces hotels

Springfield, Mass.-based David L. Babson is a rare breed in the life insurance industry — it is active in hotel financing. According to David Brassard, a senior managing director at Babson, which is a subsidiary of the Massachusetts Mutual Life Insurance Co., only about half of all insurance companies take an active interest in the primary commercial real estate mortgage market. Fewer yet lend to the hotel market, he noted.

“We're a debt provider to the full-service segment of the hotel industry, and we work only with full-service, stabilized, existing hotels,” Babson said. “Of those that do lend to the hotel market, most are clearly more inclined to deal with fully built and fully stabilized properties.”

Brassard estimates that hotel loans in 2000 made up 10% to 12% of annual loan production at Babson. “I haven't scrutinized this data,” he said. “My guess is that most of these loans would have been in the first two quarters of 2000, with a lot fewer coming in the last two.”

Is the drop-off due to fewer requests for loans? “No,” Brassard said. “The reason is that it's harder to agree on terms for the loans.”

A new kind of oversupply problem

Although lenders are always concerned about overbuilding in the hotel industry, there is another problem that is not receiving much attention.

“The problem is consolidation,” said Stephen Rushmore, president of HVS International, which is a Mineola, N.Y.-based hotel valuation and consulting firm.

“We're coming down to a handful of major companies controlling 80% or so of the brands in the market,” he said. “Each time a company adds a brand to its portfolio, it begins competing with the other brands in the portfolio.”

Consider what might happen to a Hilton serving the downtown area of a major city, Rushmore said. The Hilton may have competed successfully for years with other brands such as Doubletree and Embassy Suites. However, Beverly Hills, Calif.-based Hilton Hotels Corp. owns Promus and the Doubletree and Embassy Suites brands that formerly competed against Hilton. When customers call the Hilton reservation system today, they now receive the option of staying at those former Promus brands as well as Hilton's previously established brands.

“Through no fault of the operator, the Hilton in this city has lost the competitive advantage of being the only Hilton in the downtown market,” Rushmore said. “In this way, continuing consolidation will create problems across the industry for owners and developers.”

Ironically, as the decline in new development has reduced the oversupply problem, consolidation may create pockets of oversupply within a hotel company's lineup of brands.

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