US Economy

Before understanding the intricacies of Europe’s hotel markets, one should consider the broader economic conditions that these markets are subject to.

After nearly 10 years of growth, the slowdown in the U.S. economy in 2001 has prompted economists to ask not if, but how severe will the downturn be. Strong GDP growth in the first half of 2000 outpaced the most optimistic projections, but slowed sharply to a four year low in Q4. Economic growth estimates have been reduced by more than 50% since October 2000 as companies continue to announce profit warnings. However forecasts remain positive at around 1.8% for 2001, with the bulk of the growth to be felt in the third and fourth quarters.

In stock markets, May saw the Dow Jones index largely make up falls in March and April, returning to levels comparable with the same time last year. However, the NASDAQ index of technology stocks is still approximately 45% lower than a year ago, and nearly half the value of its peak in February 2000. The recent pessimism seen in stock markets, particularly in TMT stocks, continues with profit warnings and job cuts across the sector, and there is no doubting this has spread to the ‘real economy’.

A continued slowdown in productivity may necessitate a close watch on inflation, with the consumer price index (CPI) at a nine year high, although thus far, inflationary pressures are not restricting the actions of the Federal Reserve.

For the first four months of 2001, CPI averaged 3.4%, the same as 2000. Talk of inflationary pressure is increasing, but the emphasis remains on monetary easing to strengthen the economy and particularly business investment. Six cuts to date this year have seen interest rates bow to a low of 3.75%. Consumer confidence remains poor, falling to a four year low in April, suggesting a reduced chance of a swift rebound – although traded up slightly in May.

There is still debate over whether the slowdown will last beyond the first half of 2001. The general feeling is that this would be necessary to trigger a severe contraction in Europe. Even if the economic situation worsens in the US, the market consensus is for recovery in the third or fourth quarter, and forecasts for 2002 remain positive.

European Economy

The downturn in the global economy is being felt across Europe, with both EIU and OECD growth forecasts down-graded in 2001. However, at a revised 2.3% forecast growth for 2001, the euro-zone will be the strongest growing region in the OECD. Despite earlier resistance to rate cuts, citing inflationary fears, in May the European Central Bank (ECB) cut interest rates by 25 basis points to 4.5%. Euro-zone inflation figures released in May jumped to 3.4%, up from 2.9% in April, making further rate cuts unlikely.

In the short term at least, the key factors in judging the direct impact of US economic conditions are the strength of domestic demand, currently fairly robust, versus the level of export exposure to the US. Conventional wisdom suggests a slowdown in European economies would come about due to the US impact on world trade and the slowdown in export growth.

The relative strength of the US dollar against the Euro has served to lessen the impact, with Europe still perceived as a relatively cheap market. This is particularly relevant for the hotel and tourism industries, and suggests that should the currency differential remain static, American tourists will continue to perceive Europe as a value for money destination.

The German economy began to slow in the second half of 2000, and has more recently suffered from deteriorating business sentiment, and rising unemployment. IMF growth forecasts have been downgraded from 3.3% in October 2000 to 1.9% in April 2001. Germany is the largest economy in the euro-zone and generates a significant amount of demand for the region. It is particularly exposed to US economic conditions, due to its relatively large share of exports bound for the US, and it is felt that a recession in the US would have a more substantial impact on Germany than some of the other euro-zone economies. With falling private consumption, the possibility of strong domestic demand absorbing any export decrease does not seem likely. In addition inflation levels are running high at around
4% in June 2001, which coupled with the slowing economic growth is likely to dampen domestic demand.

In somewhat of a contrast, the French economic slowdown is expected to be minimal, with GDP growth forecasts above average, revised down to 2.6% in June 2001 from 3.3%. Although exports have slowed, this has largely been compensated for by strong domestic demand. However, a worsening situation in Germany is likely to affect France, and consumer sentiment has weakened due to concerns over the global economy, with fears it will affect domestic demand. While inflation rose to reach 2.5% in May, it is still the second lowest in Europe, behind the UK.

Belgium and the Netherlands’ relatively small population base makes them more vulnerable to wider economic influences. Lower economic growth among their trading partners would see exports, a major contributor to GDP, decline substantially. There are doubts that domestic demand, even if unaffected, would be able to compensate.
However, these economies have relatively limited exposure to the US as opposed to the euro-zone.

The Spanish economy seems to be heading for a soft landing, with slightly weaker domestic demand due largely to interest rate changes in 1999-2000. Consensus growth forecasts have been revised down in June to 2.9% for 2001 (down from last years 4.1% but still remaining healthy), before picking up again in 2002. 

Unemployment rates continued to fall, although inflation rose to 4.2% in May, with analysts predicting a fall for the second half of the year.

Despite a slowdown in exports, the underlying strength of the EU economy looks set to cushion Spain, with the proviso that a flow–on effect is not felt from poor growth suffered by its European trading partners. In addition, Spain’s structure of trade is slightly different than other European countries with strong trading links to countries
outside the US and euro-zone.

Italy has also seen a modest downgrade in GDP growth forecasts, from 2.8% in October 2000 to around 2.2% in June 2001, but appears to be well placed. Consumer confidence is relatively robust and inflation remains below the European average, at 2.9%. While its export levels to the US are less than 1% of GDP, it does, however, export to trading partners of the US, who may be hit by economic conditions there.

The Consensus forecast for GDP growth in the UK has fallen slightly, from 2.7% in October 2000 to 2.2% in June 2001. This is one of Europe’s smallest downgrades, with GDP growth predicted to return to 2.7% for 2002. Retail sales appear to be holding up well, consumer confidence is rising, and the unemployment rate is low. Business confidence is slightly less robust, with the manufacturing sector likely to bear the brunt of falling export demand due to a strong pound and the global economic slowdown. June 2001 figures put inflation at 1.7%, up on May, but the
lowest in the euro-zone. Of all European countries, the UK is the most exposed both to US exports as a percentage of GDP, and levels of foreign direct investment. The hope is that strong domestic demand would help balance any drop in export demand to the US.

European Commercial Property Markets

As a competing asset class, the commercial property markets (office, retail and industrial) should also be examined as investors weigh up portfolio allocation.
Currently the European real estate market is strong, with low vacancy rates, and reasonably controlled supply. As the economy slows, rental growth is expected to do the same, and could possibly turn negative in some markets.

However, real estate as an asset class is expected to perform well, possibly better than other classes. Today’s real estate market has a number of advantages over the one going into the recession of the early 1990s. Two key areas are supply, which is much more constrained than the last recession, and vacancy rates, which are currently looking much healthier.

Prior to the previous recession, developers rushed to exploit an increase in property values, leading to a glut of supply just as demand began to slow. Currently, supply is relatively restrained, and much new supply is pre-let. Total office take–up in 2000 was at record levels, although this is expected to fall in 2001, especially as some of the highest demand came from the TMT sector and US companies. Occupiers are more cautious due to economic uncertainty, but office rental growth is expected this year in the major European markets.

Unlike the last recession, capital is not predicted to abandon real estate. Given the recent fall in TMT stocks, markets may even see investors up-weighting to the perceived relative safety of real estate. Rental growth should still show increases, and rental returns are predicted to sit between 7% and 9%, far healthier than the negative returns of the last recession. While a fall off in demand for space and capital available for investment are to be expected in the event of a recession, both are predicted to return to normality by mid to late 2002.

European Hotel Markets

Hotel Supply Fundamentals

Similar to commercial property markets, a key factor in hotel markets’ performance and ability to withstand a potential economic slowdown is the level of supply increases. The European hotel markets under greatest pressure have seen
large increases to supply, for example some regional UK markets, Warsaw and Budapest. Similarly, during the last recession (1991-1993), markets that experienced large supply growth immediately prior suffered the most volatile performance swings. Thus the supply situation going into this current economic slowdown is likely to play a key role in assessing how well European markets will perform.

If this variable (supply) is under control, we can feel more confidence in Europe’s ability to face this US-led downturn. Compared to the period immediately prior to the last recession, the European hotel markets as a whole appear to be in a much stronger supply-based position. From an average annual growth of 6.8% between 1990-1992, growth has averaged just 4.0% annually across major European markets between 1998-2000 (London, Paris, Stockholm, Berlin, Frankfurt, Barcelona and Amsterdam).

The German markets of Berlin and Frankfurt have seen the largest recent supply increases. In the past two years Berlin witnessed double digit supply growth. However, this was higher in the previous recession when new supply jumped nearly 30% in 1991, due to planning associated with unification. At the same time demand did not increase as expected, causing hotel performance to come under severe pressure. Germany’s reunification has greatly increased the importance of Berlin as an international city, compared to its position a decade ago, generating increased demand from new market segments. Demand growth averaged 4.7% p.a. (1990 – 2000) and 11.5% p.a. (1996 – 2000). This suggests that more recently, whilst the rate of increase in supply has been significant, demand growth has largely kept pace.

London and Frankfurt have recently experienced greater supply growth compared to the last recession, however this has been matched by growing demand. Both cities are at the heart of the global financial community and as a result have enjoyed increasing demand levels. This has also stimulated significant increases in average rate.

Both Amsterdam and Barcelona have experienced reduced supply growth recently, compared to the three years prior to the previous recession, placing them in an improved position. Growth from well- diversified demand sources has enabled operating performance to flourish. Amsterdam and Barcelona saw relatively high supply growth and contraction during and post the last recession. The ensuing situation of oversupply virtually halted new hotel development until the market recovery. In Barcelona’s case, this can be attributed to the flurry in development activity associated with the Olympic Games. The moderate supply growth combined with relative economic strength suggests these markets should be in a better position to weather an economic slowdown. However, Barcelona (and Madrid) have growing development pipelines.

Stockholm and Paris have experienced low supply growth recently, with Paris recording a contraction in supply in 1999. During the last recession, quality supply levels in Paris and Stockholm remained relatively stable and the hotel markets did not suffer as dramatic an impact during the downturn. These markets are currently in the best position supply-wise to weather any downturn. However, while Stockholm has had low supply growth, this should be viewed in light of its exposure to the TMT sector, whose recent poor performance will impact negatively on demand. Paris,
with its low and stable supply growth, was the least affected market during the previous recession, and appears in a similar position in the event of a future economic downturn in Europe.

Hotel Demand Fundamentals

Regardless of whether the slowdown in the US economy spreads to Europe, European hotel markets are vulnerable (to varying degrees) due to their reliance on US demand. Paris and London are the most exposed, with approximately 30% of bed nights sourced from the US in 1999 (this refers to investment grade properties).
Amsterdam follows with around 25%. Both Paris and Amsterdam also have relatively low levels of domestic demand, making them more exposed generally to external economic conditions.

Brussels and Frankfurt have lower levels of exposure, with demand from the US comprising less than 20% in 1999. While Frankfurt has a high level of domestic demand, Brussels in comparison is heavily exposed to the economic climate in Europe, with domestic demand comprising less than 10%.

Berlin, Madrid, Barcelona and Stockholm are all much less exposed to the US market, at around 10% US demand in 1999 – potentially putting them in a better position to weather contractions in the US economy. All have relatively high levels of domestic demand (higher than 40%), Stockholm and Berlin in particular. Thus if domestic economies remain healthy, these markets are in theory also better positioned to withstand any external slowdowns.

Economic slowdown, even negative business sentiment, is widely tipped to cause a reduction in business travel (or at least a downgrading in level of accommodation utilised). While all the major markets examined have a relatively high dependence on corporate demand, at 50% or greater, some markets are more weighted to business demand than others.

Consumer confidence in most markets, particularly the UK, remains strong despite a more pessimistic view by the manufacturing sector. Unlike business demand, leisure demand appears to be holding up well with the exception of London. This could partly be attributed to the affects of foot and mouth disease, which has caused a drop in demand from US visitors. The continued buoyancy of US leisure demand is dependent on the US dollar maintaining its strength against the euro.

Thus far we have seen the upper segment of the European hotel market bear the brunt of reduced US demand with the curtailing of business travel. The mid-market hotels are likely to follow as the year progresses as the leisure market often softens following a weakening in corporate demand. Having said this, the business environment today is more global compared to the last recession with more multi-continental organisations compared to just multi-national companies. Thus there is more core demand compared to 10 years ago and once the anticipated growth resumes during the latter part of 2001 – corporate demand will replenish. It is these investment grade properties that are likely to rebound first as the major corporates have their confidence restored.

The Balance Between Supply and Demand

During the recessionary period 1991-1993, all the hotel markets examined experienced negative yield growth for a period of time, and saw both average rate and occupancy growth dip, in some cases significantly. The majority saw falls in 1991 and 1993, with temporary recovery in 1992.

Generally speaking, Paris was the most resilient, at its worst seeing yield contract by slightly more than 10% (in 1993). Frankfurt, Brussels and Amsterdam witnessed yield growth contract by between 15 - 20% at the lowest point (1993).

London, Stockholm, Madrid and Berlin suffered from the greatest falls in room yield during the last recession, with contractions greater than 20%. London and Stockholm fared worst in 1991, but managed to arrest the drop in 1993, when many other markets were hit hardest, coming out of the recession earlier.

Looking to how the European markets will fare in the current US downturn and the risk of global slowing, the supply and demand fundamentals of the individual markets are a telling sign. The next section of the report examines the relationship between supply and demand over the decade and how they are positioned to go forward.
In most markets across Europe, average annual demand growth has exceeded supply growth for the past decade.

This places the markets in a relatively healthy position, underpinning occupancy rates in particular, and potentially yields.

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Supply growth in London has remained relatively constant over the past decade, not rising above 5% until very recently. Demand contracted during the late 1980s to a low in 1991, due largely to the Gulf War, and accentuated by the global economic slowdown of the early 1990s. It recovered to pre-downturn levels during 1994/95 and has since stabilised. As an average across the decade, supply and demand growth has been moderate, at just below 2.5%, and very evenly matched, suggesting a balanced market with strong fundamentals.

London is one of Europe’s largest and most important cities, dominating the UK economy and also attracting a high level of both domestic and international visitors. Most recently visitor arrivals have softened with the combined impact of the slowdown in the US economy as well as the negative press generated by the ‘foot and mouth’ disease.

The impact of the US slowdown has been most significantly felt at the higher end of the market (four and five star supply), although the wider leisure market is likely to see the impact over the coming months. In addition, the relative strength of sterling against European currencies places London as one of the more expensive destinations in Europe and any softening in US demand is unlikely to be compensated by increases in European demand.

Paris

Paris enjoys a position as one of the financial and commercial centres of Europe, and with a strong level of tourism demand, has a well-diversified base. Demand growth has been volatile over the decade. Having suffered during the early and mid-1990s as a combined result of the global economic slowdown as well as strike action and terrorist activity in the city, demand growth peaked in 1998, with the Football World Cup.

Due to building restrictions in the city centre, Paris’ supply has remained relatively constant over the past decade, with growth hovering around the zero mark (and even turning negative in some years as hotels were taken out of the market for refurbishment). For the past few years, the city has enjoyed demand growth well above supply, which should serve to place the market in a relatively strong position in the face of economic uncertainty. Annual growth has averaged below 1.0% for both supply and demand over the past decade, suggesting Paris is a very stable market – evidenced by its success in weathering the last economic downturn better than many other cities in Europe.

Paris, similar to London, has one of the largest exposures to US demand, although at present, the city’s hotels have yet to experience a significant impact from the economic slowdown. The effect of a decrease in US corporate demand in the short term is likely to be concentrated in the upper segment. However, the mid-scale hotels should remain fairly resilient to the US downturn due to their strong reliance on European and domestic demand. In addition, the weakness of the euro against the US dollar makes travel to Paris more affordable.

Stockholm

Stockholm’s supply growth has also remained relatively constant, at most times well below demand growth levels. The leap in demand in 1993 and 1994, following economic recovery, pushed the average growth level for the decade well above supply. Demand growth in Stockholm is far more volatile than supply. This could be attributed to the fact that Stockholm demand is largely domestic (almost 60%) and business orientated, in an economy driven largely by the TMT sector, which itself has been the subject of much volatility recently. Although for the most part demand
growth has remained positive, and the market’s sensible supply growth should contribute to long term health. However, it must be noted that the city’s exposure to the TMT sector is likely to inhibit demand growth for 2001, although growth should resume in 2002.

Berlin

Berlin’s supply growth, after a number or peaks and troughs, began to even out in 1995, and has since remained relatively stable. Demand growth was not immediate after reunification and did not accelerate until the late-1990s. Over the last two years demand growth has accelerated and outstripped supply gains. The market now shows a more even balance between supply and demand after instability earlier in the decade, as Berlin adjusted to unification and became the official seat of government. Berlin is experiencing considerable redevelopment, growth in the services sector and infrastructure improvement, as well as strong conference business. This will continue to help underpin future demand growth.

However, there is still a large development pipeline with a significant number of new rooms due to enter the market. Coupled with this is the slowdown in the German economy and the high levels of inflation which are serving to dampen domestic demand - the main source of demand for Berlin’s hotels at around 70% of total bed nights. Thus the pace of supply growth may overtake that of demand once again in the short term. However, counter to this is Berlin’s relatively small exposure to the US market and the long-term outlook for the market is positive.

Frankfurt

Frankfurt, as the financial centre of Germany and a major force generates demand from the congress, corporate and trade fair sectors, which have accelerated in recent years due to the improved economic conditions. Demand reached its highest growth level in 2000. Frankfurt’s supply growth, after remaining relatively modest for most of the decade, began to accelerate in 1996 (although the majority of new additions were not in the city centre). Both supply and demand have almost consistently had less than a 5% variation, keeping growth in the market relatively in balance, one of the most stable of the markets examined. The large share of global financial institutions represented in Frankfurt may mean hotels see a slight softening in corporate US demand. However, the city centre still remains under-supplied from Monday to Thursdays as corporate and convention demand boost both occupancy and rates. Even allowing for a slight downturn in US corporate demand, there is still potential for absorption of new supply additions in the Frankfurt’s city centre.

Madrid

Madrid’s supply growth, after a previous high in 1993, has remained relatively low, only beginning to increase again in 1999 and 2000, as investors have sought to enter the accelerating market. In contrast demand has remained considerable higher than supply since 1993, suggesting a market in a healthy position. Again, the city’s supply and demand have remained in balance over the decade – possibly aided by a strong convention and exhibition market, often booked ahead, enabling demand forecasting. Madrid is coming into its own as a corporate and convention destination, as well as attracting increasing leisure demand.

The market has yet to see any impact from the US economic slowdown given its relatively low reliance on US demand and the strength of the domestic economy, which contributes a significant percentage of hotel bed nights. Madrid also continues to benefit from being a cheaper destination, both in terms of the currency differential (US dollar to euro) as well as being more competitively priced than other major European cities such as London, Paris, Amsterdam, Rome and Milan.

Barcelona

Barcelona saw a large jump in supply in 1992/1993 around the time of the Olympics, which gradually decreased, to become a contraction in 1998, before growth resumed. Demand growth slowed after the Olympics, before peaking in 1995 (as a result of the city’s newly found international profile), and remained well above supply before dropping to a more modest rate. In 2000 supply growth exceeded that of demand, potentially placing downward pressure on occupancy rates, and leaving the market in a more exposed position if demand growth was to fall. However, Barcelona’s hotels are operating at very high occupancy levels and the city authorities still believe the market is under supplied.

Barcelona, similar to Madrid, still has the advantage of being one of the relatively cheaper European destinations, which should insulate the market to some degree. Also in common with Madrid, Barcelona has an ever-expanding convention business which is still operating at capacity and has strong bookings for the coming years.

Brussels

Brussels’ supply growth has been largely constrained by building regulations imposed on the city centre, recording supply growth well below 5% for most of the decade. Demand growth, with the exception of the last economic downturn, has remained above that of supply (excluding 1998). As well as being a notable business destination, and possessing an important convention centre, Brussels is the headquarters of the EU and NATO, thereby generating demand from the diplomatic sector. Aided by this position of political importance, Brussels demand growth again
looks set to exceed supply in the medium term, placing the market in a healthy position. Whilst the market does source demand from the US corporate market, the percentage is not as significant in other European cities and Brussels’ political related demand should cushion the impact.

Amsterdam

Similar to Brussels, since early in the decade, supply growth in Amsterdam had been constrained due to lack of suitable sites in the city centre, and competition for space from the strong office market. Demand growth showed a contraction in 1993, before recovering to levels above that of supply (until recently). In 2000, demand growth fell below that of supply, actually registering a contraction – this can largely be attributed to a ‘bad year’ in the RAI’s biennial convention cycle, combined with their targeting higher yielding more specialised trade fairs and exhibitions, with smaller numbers of attendees. While occupancy remained strong in 2000, trading information for the first three months of 2001 shows Amsterdam, in particular airport hotels, under pressure. However, the average annual growth across the decade shows demand and supply growth fairly evenly matched.

In addition the hotels in the city centre are reliant on US leisure demand (rather than corporate) which remains robust. US consumers are still spending and the US dollar/euro exchange rate is favourable, making Amsterdam an attractive leisure destination. This position may change if the US slowdown deepens.

Prague

While leisure demand is increasing in Prague, city authorities also intend to attract additional conference and incentive business – greatly aided by the successful IMF conference last year. As the gateway to central Europe, Prague enjoys a strong position. More recently supply has exceeded demand (2000 excluded) as the market has historically been somewhat supply-led. The new high quality hotels that have opened in recent years and those still in the pipe-line are likely to attract additional international demand.

Prague’s hotels are heavily reliant on international source markets and thus the strength of these economies, particularly US and Germany, will have a direct impact on performance. The market has yet to witness a significant impact, although should the US downturn deepen, the market may come under pressure.

Implications

Given the previously discussed indicators, some markets appear to be in a stronger position to weather a potential general economic downturn in 2001 than others.
However, what is apparent is that most markets are enjoying higher growth in demand compared to supply than at the beginning of the decade, or at least a better alignment of the two. Most markets also show a less marked pattern of highs and lows, with both supply and demand growth more manageable. Local authorities will play an important role by keeping planning permissions to a minimum in order to maintain this balance.

The effects of the previous downturn illustrated the dangers of huge increases in supply, and the risk of relying on continuing increases in demand to match and adsorb the new additions. Periods of economic uncertainty serve to remind that even buoyant markets lack invincibility, and the importance of maintaining manageable supply growth. It is felt that a ‘reality check‘, resulting in a slowdown in supply growth, would benefit markets by supporting occupancy levels.

The markets (and companies) who weather times of economic slowdown best, are those who take a more restrained, longer term view. Times of economic uncertainly often serve to rationalise the market, when investors keen to reap short term dividends exit as the markets mature, and those without the resources to survive the troughs are forced out.

In addition, the current conditions where investment sentiment is slightly weaker represent a good time to buy. As long as the local market fundamentals are relatively well balanced, there are opportunities for those investors with a more medium-term view to achieve attractive returns.

Conclusions

On the whole the fundamentals of the European hotel markets remain strong, with supply growth largely at manageable levels. However, should the downturn in the US spread to Europe, performance will come under increasing pressure. As well as a more manageable supply base, the economy is vastly more global than the early
1990s and there is a larger core demand base. Thus the corporate market is likely to rebound much faster than the last downturn. The following SWOT analysis summarises the position of Europe at its hotel markets at the current time.

SWOT Analysis

Strengths

• Supply control in many markets.
• Euro low against the dollar, stimulating inbound travel from the USA.
• Relative interdependence across the euro-zone providing some insulation from situation in USA.
• Most markets in fairly strong position in the current cycle.
• Better alignment of supply and demand growth trends.
• Consumer confidence in most markets, and the US, currently holding up better than the manufacturing sector.

• Economies across the euro-zone linked, particularly by exports – poor performance in one area will affect others.
• UK quite heavily reliant on US demand, and already experiencing a drop from this market segment.

• Slowing of construction in some markets as investors are more cautious.
• Interest rate cuts to stimulate consumer demand.
• Accelerated growth following economic downturn.
• Investment opportunities where sentiment is weaker.
• Consumer confidence is still holding up on both sides of the Atlantic.

• Supply growth outstripping demand, particularly if planning permissions continue to be issued.
• If US economy enters a recession, a dramatic drop in demand from this sector.
• Influential economies in Europe eg Germany and the UK dragging down others initially better placed.
• US situation causing an erosion in consumer confidence and curtailing travel irrespective of economic situation.
• Business travel on hold during economic uncertainty.

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Our recent track record for the last two years alone included the sale of 13,994 hotel rooms to the value of US$1.4 billion in 48 cites and advisory expertise for 173,021 rooms to the value of US$32.6 billion across 343 cities.

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