Hotel Value Drop Constricts Development Pipeline

As hotels continue to suffer from a steep decline in business travel, the capital markets have been successful in keeping a tight lid on the development pipeline. In the first half of the year, hotel valuations and the number of property sales were down significantly, lending further evidence that the lodging industry is in distress. However, analysts last month predicted an upswing in transactions in the coming months.

A slowdown in the development pipeline is good news for suppliers, since it keeps new competition out of markets where demand already is weak. Meanwhile, potential hotel buyers—sensing that prices may be trending lower—are skittish about committing to deals.

The lodging industry already is hungry for a rebound in occupancies and room revenues. Adding more uncertainty to the picture gives travel buyers a further psychological advantage going into the upcoming negotiations for 2003 rates.

According to Lodging Econometrics, a Portsmouth, N.H., consulting firm, the pipeline for new hotel development dropped again in the first quarter of the year, but the rate of decline was the slowest since 4Q00. "The industry will open about 80,000 new rooms this year," said Patrick Ford, the firm's president. "Once closed projects are subtracted from the census, this will represent a 1.8 percent increase in supply."

More significantly, Ford pointed to a disparity concerning the top 25 U.S. markets, where business travel tends to be concentrated. While these markets constitute 32 percent of the country's opened and operating guest rooms, they account for 43 percent of all rooms under construction and 41 percent of all rooms scheduled to begin construction in the next 12 months, he said. Specifically, he cited Boston, Chicago, Detroit, Miami, New Orleans and Orlando as markets where either "recent supply additions remain to be absorbed and/or where new supply will be significant in 2002."

Consequently, buyers who bring a lot of room nights to these markets will want to use this as leverage in negotiations with their existing suppliers. Alternately, new properties in a market may be open to negotiating attractive rates as a way of building trial usage.

With supply growth in decline and capital unavailable for new hotel development, attention has focused on the value of existing properties. Because of the recession, however, values often have been below replacement costs. "It doesn't make sense to build a hotel, if you can buy one for less than the replacement cost," said Stephen Rushmore, president of HVS International, a Mineola, N.Y.-based hotel appraisal firm.

Overall, U.S. hotels experienced a decline in value of 10 percent in 2001. Cities that experienced the steepest declines during the year included Boston, New York, San Francisco and San Jose, the decline in each being 30 percent or more. "Because they were centers of the dot-com technology, Boston and San Jose really suffered. It wasn't only a supply problem they faced, but a demand problem as well," Rushmore said. Indeed, both destinations experienced serious declines in occupancy and average daily rate and, consequently, in revenues.

Similarly, it will take hotel values in Boston, New York, San Francisco and San Jose the longest to return to 2000 levels. "That was the banner year and we project it could take six years for values in these cities to fully recover," he said. "For U.S. hotels overall, the rebound should take four years."

In the same way that occupancies and room revenues at deluxe and upper upscale hotels most negatively have been impacted in the recession, the value of hotels at these price points has suffered the most severely. "Upper upscale hotels were hit the worst by the downturn and are expected to lose 7 percent in value in 2002," Rushmore said. By contrast, midprice hotels without food and beverage and economy hotels each are expected to decline only 2 percent in value.

Given this environment, it wasn't surprising that the number of major hotel sales fell precipitously in 2001 from the prior year. According to HVS statistics, 105 such transactions occurred during the year, down from 150 in 2000.

The same forecast applies to 2002, said Anwar Elgonemy, an associate at Jones Lang LaSalle Hotels, a hotel investment services firm in Coral Gables, Fla. "While opportunistic buyers have been smacking their lips in anticipation of a feeding frenzy, very little food has been brought to the table," he said.

Yet, Elgonemy sees the scenario improving in the second half of the year. "As the economy and, subsequently, the hotel market recovers, investors' confidence should build. The absence of new supply will act as a stimulant. Plus, there will be pent-up demand following almost a year of relative uncertainty and inactivity," he said.

Hotel sales are most likely in markets where not much new supply is coming online and there's been a significant falloff in demand, Rushmore said. Fort Lauderdale, Houston, San Antonio and Tampa best fit this profile. "The dynamics of the market show an upturn in value in these cases," he said. Similarly, Rushmore would hesitate to purchase hotels today in cities where the outlook was for continued supply growth.