Hotels, Motels, & Inns: The Capital Cycle Rolls On

Over the past six years, the hotel industry experienced a strong recovery in demand for hotel space. This demand drove room rates higher, lifting them to levels, in real terms, last seen in 2006. Despite this rise in profits, hotel operators forestalled building new hotels for several years. This occurred despite very easy lending terms from banks and other financial institutions for Commercial Real Estate Loans. Instead, they used the free cash flow to repurchase stock, raise dividends, and buy each other. This kept industry capacity growing less than demand and enabled operators to raise room rates, known in the industry as Average Daily Rate (ADR), by 5% to 8% for many years driving industry margins higher, as expenses grew at a low rate.

With industry margins at close to record levels, operators have finally given into temptation. They have committed themselves to add new hotels to their portfolios and to expand their existing properties. With debt cheap and margins high, this looks like a winning proposition. But just as occurs in many industries, hotel operators appear to all be doing this at once. Thus, industry capacity growth is beginning to accelerate at the same time as demand growth is slowing. A few statistics will put some perspective on this accelerating supply growth. Industry rooms, as of July, totaled ~5.1 million (5,083,748 to be precise). Rooms that had been opened over the past year totaled ~92,000 or 1.8% of existing rooms compared to just ~78,000 a year ago. Rooms under construction totaled a little over 171,000 compared to 129,000 in July 2015. Rooms in final planning, soon to become rooms under construction, totaled almost 197,000 or almost 4% of industry capacity. And the total active pipeline reached over 529,000 rooms, greater than 10% of industry capacity, compared to just 431,000 a year ago. The following table will put some historical perspective around these statistics:

Year End    Under Construction    Supply Change    REVPAR Growth

2004            2.0%                                0.2%                     6.8%
2005            2.2%                                0.0%                     8.6%
2006            3.5%                                0.2%                      7.7%
2007            4.7%                                1.2%                       6.1%
2008            3.9%                                2.4%                     -2.0%
2009            2.0%                                2.8%                    -16.6%
2010             1.1%                                 1.7%                       5.4%
2011              1.1%                                0.4%                       8.1%
2012             1.4%                                0.4%                       6.6%
2013             1.8%                                0.6%                       5.2%
2014             2.4%                                0.7%                       8.2%
2015             2.8%                                1.1%                        6.2%
2016E          3.5%                                 1.9%                       2.9%
2017E          4.4%                                  2.5%                        ?

Data from STR and Deutsche Bank Securities Inc.

There a few key observations from the above data. First, the level of construction relative to industry capacity is the highest since 2006, with 2017 forecast close to peak levels of 2007. Second, industry capacity growth has begun to accelerate and will exceed 2008 percentage growth levels in 2017. Third, industry REVPAR growth is inversely proportional to supply growth. Fourth, should a recession occur late decade, industry supply growth will be accelerating into a significant drop in demand.

In addition to the issues with supply, costs are beginning to accelerate. Labor is one of the significant costs for the industry. With unemployment low and wage rates accelerating, costs are rising. In addition, many large states have enacted increases in their minimum wages over the next few years. This will further impact wage rates for a large portion of the industry through 2020. Besides costs, the industry needs to watch several bills in Congress. The industry has tacked on a large number of charges for items that used to be included as part of the room charge. This is especially true for the large resort properties. The proposed bills would force disclosure of the total cost of the hotel room including all ancillary charges, whether for the workout room or beach towels. This would likely put pressure on industry profits, as the true cost of staying at these properties would be revealed. Given the role of the internet in 99% of hotel bookings today, it would enable the consumer to compare like for like and put pressure on the industry as operators were forced to compete on the total cost of staying at their properties.

For the hospitality industry, the future looks somewhat less rosy than the past five years. At the heart of this is The Capital Cycle. Industry returns have risen to a level that more than justifies new construction, especially given today’s inexpensive debt financing. And the industry has climbed on board with the expected consequences. Supply growth is accelerating. REVPAR growth is decelerating. And costs are rising. And, just to top it all off, as if this were not bad enough, potential regulation looms on the horizon. With all these actions set in motion for Hotels, Motels, and Inns, in merciless fashion, The Capital Cycle Rolls On. (Data from STR Global and Deutsche Bank coupled with Green Drake Advisors analysis.)

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