Lodging Sector Update

Hotel investment settles in for a long stay.

As the lodging real estate cycle enters its second year of expansion, the hotel industry is booming. Guest room occupancy finished 2014 at 64.4 percent, while revenue per room posted an astounding 9.2 percent year-over-year increase, according to Smith Travel Research. Average daily rate and revenue per available room are both at record highs, while hotel occupancy and room revenue reached their highest levels in more than 15 years.

In 2014, guest room demand increased 4.5 percent YOY, while the growth rate for new supply was less than 1 percent. Lodging Econometrics analysts noted that all 25 top markets showed occupancy, ADR, and RevPar rates up over 2013. Demand growth exceeded supply growth in all 25 markets and outpaced supply by more than 2.5 percentage points in 20 of those markets. Just three markets registered supply growth greater than 2 percent: Denver, Nashville, Tenn., and New York.

A continued uptrending of these operating metrics will soon quicken the pace of new hotel construction and will also increase transaction volume and further escalate selling prices. Improving metrics will encourage real estate investment into the maturity phase of the cycle, anticipated to occur toward the end of the decade.

Construction Poised to Break Out

The hotel construction pipeline struck bottom in 2011 with 2,753 projects and 334,712 rooms. In 2014, the pipeline experienced its first year of significant growth, rising to 3,645 projects and 460,551 rooms, a substantial 20 percent YOY growth rate that freed the pipeline from what had been a two-year bottoming formation. (See Table 1.)

Unlike other real estate sectors, such as office, multifamily, and industrial, hotel development has been slower to react to the improving economy. For instance, only two major markets have more than 100 projects in their pipelines: New York with 188 projects and the sprawling Houston market with 148 projects. In comparison, five markets had more than 100 projects under development at the previous cycle’s peak in 2007.

Development is currently concentrated in select-service, lifestyle, and mid-market properties. These include Marriott’s Courtyard, Residence Inn, Spring Hill Suites, Town Place Suites, and Fairfield Inn; Hilton’s Garden Inn, Hampton Inn & Suites, Home2 Suites, and Homewood Suites; IHGs’ Holiday Inn and Holiday Inn Express; Starwood’s Aloft; and Best Western’s Plus.

With the economic and financing environment near perfect, development of these property types is expected to gather even greater speed. The economy is being driven by strong business activity, solid job creation, falling unemployment, lower energy prices, mild inflation, and improved consumer confidence. Interest rates are low. Construction and takeout financing are readily available at attractive rates.

The internal metrics that will signal a maturing pipeline will likely be similar to what occurred in the previous real estate cycle: a preponderance of new project announcements for large luxury and big-box meeting-oriented hotels located in major downtown and suburban locations, as well as a flood of large hotels to be built in major resort areas. Shortly thereafter, projects exiting the construction pipeline as new hotel openings will push annual supply growth above 3 percent, providing a natural brake to the development cycle later in the decade.

Transaction Volume Still Sluggish

Transaction volume bottomed in 2009 with 528 reported transactions and property transfers, marking a low for the previous cycle. In 2014, 1,292 hotels transacted or transferred ownership. Over the last five years, total transaction volume has ranged between 1,261 and 1,457 hotels, a narrow range far distant from the 3,218 transactions and transfers reported in 2007. (See Table 2.)

In 2014 there were 799 single-asset transactions and 481 hotels changing ownership in portfolio sales. A mere 12 hotels were recorded as part of merger activity, indicating that any significant industrywide consolidation of companies and brands may still be a few years away.

Most portfolio transactions consist of select-service hotels — the favored hotel type for private equity groups that assemble portfolios. Equity group buyers will often reposition certain hotels further up market with a new brand to extend their product life cycle, while other hotels undergo a less comprehensive renovation program to bring them current with the existing brand’s standards. Portfolios are generally sold after a five- to seven-year holding period, often to other equity groups. Frequently the sale proceeds are quickly reinvested to assemble new portfolios, a particularly opportune strategy today since there are still a number of highly profitable years remaining before the current cycle ends.

Real estate investment trusts and high net-worth investors were significant purchasers of large luxury and upper-upscale hotels that come to market infrequently. When combined with private equity groups, these investor groups collectively created a shift in 2014’s transaction mix. For the first time in this cycle, more than 50 percent of all hotel transactions occurred in luxury, upper-upscale, and upscale chain properties.

Selling Prices Rise

Total lodging industry investment in 2014 was $30.8 billion.

Of the 1,292 hotels that were transacted, 935 reported a selling price into the public domain and had an average selling price of $156,002 per room, up a dramatic 20.6 percent YOY. (See Table 3.)

The healthy increase in selling prices is due to low interest rates and the availability of attractive financing terms. Prices are further driven by the intense competition for large, well-located high-end single assets and upscale portfolio opportunities. LE foresees prices continuing to rise for the next few years as financing is likely to remain accommodative and competition for these assets intensifies.

Buyer and Seller Activity

For all hotels with a reported selling price, investment totaled $22 billion. Equity funds were the most active investors in 2014 purchasing $7.4 billion in hotels, most of which were part of portfolios. (See Table 4.)

Publicly traded REITs were the next biggest acquirers and invested $6.4 billion, primarily purchasing high-profile single assets divested by privately held hotel companies and individual owners. Privately held hotel companies were also significant buyers, investing $4.4 billion, mostly in single assets and smaller portfolios.

The biggest sellers in 2014 were privately held hotel companies and equity funds. Buy- and sell-side dollar totals for equity funds are usually in approximate balance because they frequently trade their portfolio to one another. Minor variances in the totals can typically be attributed to when funds either add or prune hotels from existing portfolios.

A Sweet Spot Ahead

As the second year of the cycle’s expansion phase begins, the industry finds itself entering a significant sweet spot. The economy is solid, hotel operating metrics are at or near record highs, and hotel profitability is very strong. Interest rates are low and funding is readily available. The foreseeable future is very bright.

For developers, rapidly increasing selling prices have already made it cheaper to build hotels than to buy. Soon new project announcements entering the construction pipeline will quicken and, two to three years later, exit the pipeline as new hotel openings. That surge of new supply, coupled with a slowing economy and tapering hotel performance, will signal the end of this real estate cycle. It will be preceded by a flurry of Wall Street activity as the industry consolidates companies and brands.

After a slow start to the recovery, there is mounting optimism that great opportunity is ahead for the hotel industry. A solid four to five year run up is possible, barring any unforeseen exogenous event.

Patrick H. Ford is chairman, CEO, and founder of Lodging Econometrics, National Hotel Realty, and New England Hotel Realty. Contact him at www.lodgingeconometrics.com.