Room to Grow
Riding a decade of growth in occupancy and revenue, the hospitality sector remains attractive to investors, despite warning signs.
The hospitality sector had a banner year in 2018. Travel research firm STR reported that U.S. hotel revenues reached $218 billion, an all-time high, up $10 billion from 2017. House profit - despite increasing labor costs - also topped records at $80 billion. Occupancy and revenue per available room, or RevPAR, have grown each year over the last decade. In its Hospitality North American Investment Forecast for this year, Marcus & Millichap predicted a 66.5 percent occupancy rate - an increase of 0.3 percent over 2018 and a 30-year record high.
But exciting numbers like these are tempered with a matching underlying concern: How long can this last? And what challenges might be ahead?
Several factors have contributed to high occupancy rates. Skyler Cooper, national director of Marcus & Millichap's National Hospitality Group, points to the extended period of U.S. job growth, combined with higher earnings and consumer confidence - all of which support increased spending on both leisure and business travel.
Cooper also notes an influx of foreign investment in the sector. As of May, the proportion of foreign investment in hotel sales by dollar volume was 12.3 percentage, similar to the 15.1 percent rate from 2018, based on sales of $2.5 million and more. Investors include companies from Canada, Hong Kong, Germany, and the U.K.; markets with the highest proportion of foreign investment are New York, San Diego, and Miami.
Areas with the highest occupancy rates don't come as a surprise; Marcus & Millichap's top five for May, for example, were New York, San Francisco, Los Angeles, San Diego, and Orange County, Calif. Leah Dauer Murphy, executive director and national practice leader for hospitality and gaming at Cushman & Wakefield, adds gateway cities such as Miami, Orlando, and Boston to the list. “They're always going to have that potential for growth,” she says. “However, a lot of them also have high barriers to entry - the availability of where you can develop and higher costs, and it takes longer to get projects done.”
As a result, she adds, “We've been seeing a shift into secondary and tertiary markets that have lower barriers to entry, but it's very crowded in that space. Nashville, Tenn., and Austin, Texas, have an incredible amount of new supply; Detroit is getting a good chunk, as are Seattle and Chicago. A lot of these markets are big group markets, too, and they want to get those large citywide events to help offset some of this new development. Some are built for conventions, and now they've got to deliver on that.”
One other trend that Murphy sees is “a lot of markets that historically didn't have product to support leisure demand are now popping up with small hotels. It's not a complete 'build it and they will come' situation; you've got to have some core demand generators in the market. But we see them in vacation-oriented seasonal markets, as well as some suburban markets that may, for example, get business travelers during the week and then be able to host larger family groups or amateur sports competitions on weekends.”
Part of the reason for gains in smaller markets, Cooper adds, is that there's generally less construction activity than in larger markets, and so existing properties benefit if there's increased travel to the area. But future growth in these areas, he says, can be difficult to predict because visitor demand can be subject to changes in both the overall and local economies.
Tourist demand isn't the only factor in areas with drops in occupancy rates. Market performance can lag, Cooper says, in areas where hotels were added in anticipation of a major event, such as the Super Bowl. Weather and natural events can also take their toll; while a natural disaster can bump short-term hotel demand - because of the need to house storm disaster victims as well as media and rescue personnel - occupancy can struggle in the following year. Houston's occupancy rate, for example, dropped by 6.4 percent from May 2018 to May 2019, thanks to 2018's Hurricane Harvey.
“We've been seeing a shift into secondary and tertiary markets that have lower barriers to entry, but it's very crowded in that space. Nashville, Tenn., and Austin, Texas, have an incredible amount of new supply...”
- Skyler Cooper, Marcus & Millichap
Notable leaders in 2018 were independent and economy hotels. Independent properties, Cooper says, are appealing to travelers seeking authentic local experiences and can capitalize on their knowledge of the market. Economy hotels are boosted by cost-constrained travelers with few alternatives, he says, and such hotels face lower competition from new supply; only about 4 percent of hotel rooms under construction are economy.
In a similar vein, Mark Woodworth, national practice leader of CBRE Hotels' Americas Research, notes that lifestyle hotels are also becoming increasingly popular. Such hotels he says, are smaller, “positioned at the 3.5- to 4-star level” and offer upscale design features such as common areas focused on social gatherings and trendy food and beverage options. Woodworth also notes one other rising property type: focused-service hotels that generally offer smaller guest rooms and a reduced complement of services, thus requiring fewer employees.
Luxury hotels, on the other hand, experienced a 2.1 year-over-year RevPAR change as of May, according to Marcus & Millichap research, but reported occupancy dropped 0.6 percent, in part due to a slowdown in luxury construction, which represents only 3.2 percent of the current pipeline.
Murphy says she also sees growth in extended stay properties with a new angle - more tiers are being created within different brands, so now there are midscale and upscale options as well. In fact, the overall proliferation of tiers within brands in general could create some confusion among travelers. On the other hand, she says, “consumers are savvy enough now that they're not just shopping purely on the brand or the name. They can hop on a website and see what the room has and what's on site. I don't know that the brand and product type are as important as they have been, just because people have so much information at their fingertips. Still, they're interested in their loyalty rewards, too, so they do have to stick within that family.”
Despite the growth and the current health of the sector, those within it need to look to the future. Potential challenges, Cooper says, include increasing labor costs, trade tensions, an aging U.S. travel infrastructure that could slow travel, and slowing economic momentum. Murphy says competition for labor is also tight. “If you have contractors who have the capability to do hotels, they also have the capability to do multifamily or mixed-use products,” she says. “And since we've seen a lot of growth in those sectors, you're competing with those product types.”
Just as important, she adds: “It's really critical for these hotel developments to get timed properly. We've been seeing timing on projects shrinking, especially on the limited service/flex service side. It's been interesting to see folks who are trying to do new hotel development now because of where we are in the cycle. We've had 10 years of expansion, which is an unprecedented length in the economic cycle for hotels, so there's been this uncertainty on when the next correction is going to be. You've got projects that have to open before that happens. If you don't, you're going to be scrambling, competing against existing hotels with existing bases of business.”
Hotels also face the increased popularity of short-term rental services such as Airbnb and VRBO. Marcus & Millchap's Cooper points out that it's uncertain how these services could perform in the event of an economic downturn, because they were less common during the last recession.
“[There's been a] shift in attitude. I feel like a year or two ago, there was almost a panic. There is still some concern, but now they've been in the market for a while,” Murphy says. “Hotels have survived, and they've continued to grow occupancy. Yes, they haven't been able to grow average rate as much, and I think a lot of people blame Airbnb and VRBO whenever hotels get too expensive. But they're not going away, and operators know that now. Also, cities are passing regulations, trying to make it an even playing field. That's helping, and that's also giving people pause to rent out their units.”
Because more markets are performing at above-average occupancy levels, CRE professionals looking to make investment decisions need to look at factors other than occupancy rates. Woodworth says that “investors should focus on other measures, such as the average room rate growth and the level of new supply that has recently opened or may be under construction, as well as economic indicators such as population growth, increase in the labor supply, employment growth, and infrastructure investment.”
Cooper emphasizes demand, because “hotel-room demand changes can manifest in the occupancy rate, but also in other metrics such as average daily rate and RevPAR.” For example, he says, in a market experiencing a change in hotel demand, investors should question whether the change is marketwide or specific to one location, chain scale, or service level.
Investors also need to be cognizant of financing. “A lot of lenders and equity investors out there are interested and willing to lend in the hotel space - they're looking for good products,” Murphy says. “But I've been hearing that they're just not finding 'good enough' deals. It's a hard sell right now within the hotel space in markets where we're reaching unprecedented occupancy levels - you have high occupancy with not a whole lot of rate growth. But you've got increasing property taxes and increasing labor costs that aren't affecting net operating income (NOI), so it's been more challenging for financing.”
Woodworth notes that to position safely for a downturn (“which we do not see happening within the next three to five years”) owners should avoid “over-leveraging their assets. Given the high fixed cost nature of hotel operations, excess debt can be a significant issue. However, because the average U.S. hotel is achieving an atypically high occupancy level and considering lending standards have been relatively conservative in the current cycle, we do not see this as a problem for most property owners today.”
Murphy cautions that investors need to consider their timeline when planning ahead. “Historically for hotels we might see a hold of three to five years at the low end,” she says. “But we've been seeing that expand to seven to 10 years because of where we are in the cycle.
“Take a hard look at how you're operating the property. When your occupancy declines overnight, you have to shift your model significantly to maintain your profitability, so start preparing for that now. Look at your areas of efficiency and have strategies in place to streamline. Look at the strength of your management team, its ability to tap into local markets and trends, and how you're positioning yourself to competitors.”