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Once Again, it is Time to Ask: 
To Buy a Hotel or Build a Hotel?

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by: R. Mark Woodworth, August 2005
 
 
“What has once happened will invariably happen again, when the same circumstances which combined to produce it, shall again combine in the same way.”
 Abraham Lincoln, Springfield, Illinois, December 26, 1839

When contemplating these sage words uttered by Lincoln over 175 years ago, we once again asked ourselves the question:  are the historic market conditions that stimulated new construction in the past now appearing on the horizon?  If so, are we likely to see overbuilding in certain markets and/or of certain property types as we have traditionally seen during past lodging recoveries? Or are the market fundamentals different this time such that the equilibrium point at which new hotel development is warranted has shifted?  The short answer is ….. perhaps!

The flow of investment capital into the U. S. lodging industry dramatically increased in 2004, and expectations are for more of the same during 2005 and beyond.  Key drivers of this market behavior include:

  • The juxtaposition created by the highs of the dot.com bubble of in the late 1990’s and the lows of the post 9/11 period created levels of market uncertainty that were arguably unprecedented.  The ensuing series of world-events ran their course through mid 2003, and investor sentiments remained subdued as supply growth trickled to a virtual halt.
  • Since the third quarter of 2003, demand growth in most markets started to accelerate, and occupancies began to recover.  While the revenue transfer from property owner to the online intermediaries served to mute the return of pricing power that traditionally comes with sustained occupancy growth, average daily rates began to accelerate in the second half of 2004. 
  • In 2004, occupancy and rate growth resulted in a 7.6 percent increase in unit-level hotel revenues, which in turn led to an 11.4 percent increase in profits for the year, thus ending a three-year decline in industry profitability.  Given the strength of industry fundamentals, profit growth should continue to be considerable at least through 2006.
Demand levels begin to expand - occupancies increase – room rates accelerate – profits go up – investors move to buy existing assets - - developers start to build?  Normally the answer is yes!  However, several current market factors critical to the economic justification of new construction suggest that the answer may still be no.
  • Perhaps most revealing is that the nominal level of Profits per Available Room (defined as income before capital reserves, debt service, rent, income taxes, depreciation and amortization) in 2004 was roughly the same as in 1996. Interesting, 1996 represented the year in which supply growth began to accelerate dramatically, a condition that characterized the U.S. lodging industry for the balance of that decade.  In fact, based on data compiled by Smith Travel Research, the national annual increase in available lodging supply during the period 1996 through 2001 was almost exactly two (2) times the level of annual supply growth for the preceding six year period.  We will not see such a run-up in supply during this recovery.  Based on data developed by the Bureau of Labor Statistics, the Consumer Price Index increased by over 20.0 percent from 1996 through 2004.  The current outlook for U.S. profitability growth is substantial; however, it will likely not be until the end of this decade that profits have fully recovered in real terms. 
  • The challenge to developers created by the need for a return to profitability in real terms is further complicated by the dramatic increase in land prices and certain key construction materials such as steel, concrete, and wallboard.  Land values have been driven up by the strong housing markets in many areas of the country, a phenomenon that may be attributed to shifting domestic demographic conditions and the notion of an “ownership society”.  Demand for steel and concrete from emerging markets around the world, particularly China, have far out paced available supply, and significant price increases have resulted. These trends raise the “cost bar” for hotel development.


Supply Growth – 
1990s vs 2000s Stronger In - Weaker Out this Time Around

2004 Property Level Operating Profits
Back to 1996 in Nominal Terms

While the strong flow of capital into U.S. lodgings has served to escalate hotel property values significantly since 2002, they have yet to reach replacement levels in most markets.  The atypically large spread between market values and replacement costs, caused by the decline in real hotel profit levels while construction prices grew dramatically, will likely persist through 2006.  As such, building will be difficult for most developers in the near term, and investment dollars will continue to seek existing assets.  Rest assured, however, that the cycle will continue to evolve and shovels will be breaking ground in significantly larger numbers well before the end of this decade.  Thus, as Lincoln noted, “what has happened will invariably happen again”, only this time a little more slowly than usual.

R. Mark Woodworth is Executive Managing Director of PKF Hospitality Research.  He is located in the firm’s Atlanta office.

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Contact:

Robert Mandelbaum
Director of Research Information Services
The Hospitality Research Group
3340 Peachtree Road, Suite 580
Atlanta, GA 30326
(404) 842-1150, ext 223
robert.mandelbaum@pkfc.com
www.pkfc.com

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Also See: The Hotel Terminal Cap Rate Delimma / PKF / August 2005
Fewer Hotels Deficient on Interest Payments; Low Interest Rates, Refinancing, and Rising Profits Are Major Factors / PKF Study / July 2005
Growth in Hotel Food and Beverage Revenues Lack the Same Kind of Sizzle Found in Room Revenues; Expense Controls Help Profits Grow / PKF Study / July 2005
Conference Centers in the U.S. Saw Financial Fortunes Turn Around in 2004 after Three Consecutive Years of Declining Revenues; Estimating 9% Increase in Conference Attendance in 2005 / PKF / May 2005
President Bush's Push for Tax Reform; Any Impact on the Hospitality Industry? / Kevin F. Reilly / May 2005
U.S. Hotels Staff Up - Rising Benefit Costs at Highest in 15 Years / Mark Woodworth / May 2005
Hotel Guests Not Picking Up the Phone / Robert Mandelbaum / April 2005
Are Hotel Employee Benefits Really Soaring? / Gregory J. Miller and Robert Mandelbaum / March 2005
Plying the Per Diems: How Market Forecasts Should Impact Hotel Rate Strategy / Gregory J Miller / PKF / February 2005
Double-Digit Profit Growth for U.S. Hotels in 2004 and 2005; Strong Revenue Growth Overcomes Some Expense Concerns / PKF / February 2005
Hotel Construction Signs Along the Road to Recovery; Measuring Hotel Developer Intent / R. Mark Woodworth and Robert Mandelbaum / January 2005
Understanding the Recovery Occurring in the Meeting’s Market; Surveying the Meeting Planners / Robert Mandelbaum / December 2004
First Half 2004 Hotel Profits Solidify 2005 Outlook; Industry Still Lags Far Behind its Past Peak Performance in 1998 / HRG & PKF Consulting / December 2004
Room Rates Across the Top 50 Hotel Markets in the U.S. Will Increase by 3.7% in 2004; Five Highest and Five Lowest Average Daily Room Rate Hotel Markets in 2005 / December 2004
Perspectives on the Road to Recovery - U.S. Lodging Industry 2005 / HRG & PKF Consulting / November 2004
Other Revenue Is Good Revenue / Robert Mandelbaum / November 2004
Uncanny! Hotel Occupancies “Key Indicator” of Presidential Election Outcome / October 2004
Is the Hotel Industry Smart Enough to Avoid Overbuilding; Ten Reasons Why Real Estate Markets Become Overbuilt / Jack B. Corgel / July 2004
PKF Consulting/HRG Survey Forecasts Banner Year for Hotel Transactions; Investors Favoring the Full-service Segment / May 2004
First Uptick for Hotel Industry in Three Years; Full-Service Hotels Lead the Way In U.S. Hotel Profits for 2004 / Hospitality Research Group / March 2004
Demand in the Full-service Hotel Sector is Expected to Increase by 6.3% in 2004; Best and Worst Hotel Markets in Terms of RevPAR Growth / PKF Consulting / January 2004


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