Ms. Watson

Development & Construction

Hotel Development: The Risk of “Something for Nothing”

By Julia Watson, Project Director / Sr. VP of Business Development, FARROW Commercial, Inc.

As the bottom fell out of the United States housing market in 2007 resulting in a crash of both the domestic and global economies, hospitality construction nationwide came to a near-screeching halt. The almost immediate cease on hospitality construction which was rooted in the prime mortgage sub-crisis coupled with high oil and commodity prices, consequently led to a radical economic slowdown.

As a result, many constructors within the industry were forced to shut down their operation, while others laid-off employees, decreased overhead, and reduced their prices to survive the recession.

In the short-term, hoteliers have been able to take advantage of incredible savings from drastically reduced rates, but the long-term effects of this behavior may prove risky for both construction service providers and hoteliers alike.

The probability that hospitality construction will soon recover from this cyclical conundrum, while unrealistic expectations for pricing become more and more entrenched, is slim. As the crunch for reduced fees gets more severe, desperation to sustain may lead to increased use of unskilled and illegal labor, additional bankruptcies, and further default on contracts, putting both the project and investors in jeopardy.

In order to understand the possible ramifications of the economy on hospitality construction, we must first explore how we got to this point. As we entered into the decline of new-development and hospitality renovation projects following the crash of the housing market, competition among service providers increased exponentially. As a result, prices took an immediate hit.

Additionally, hoteliers who had more time on their hands due to slower construction schedules began to realize their ability to shop numbers and solicit numerous competitive bids. Where reputation and quality of service once mattered, getting the most out of what little money hoteliers were able or willing to pay became the precedent.

With little influx of available money to fund construction projects of any kind due to lack of financing and tightening of credit conditions, margins thinned and service providers became increasingly desperate.

As the flow of cash into hospitality construction slowed to a trickle, those forced to do what they could in order to stay in business reduced prices to rates at or below cost. The hardships of initially only a few hospitality contractors resulted in a new low-price standard that impacted the collective-whole.

With the obligation to drastically reduce prices by those vying for a piece of the limited available work load in hospitality construction, hoteliers began to adopt a new, cheaper expectancy. This belief posed another challenge for contractors; working for less while costs of production increased.

The fall-out of the housing market left other countries with little faith in the U.S. economy and dollar, radically decreasing levels of foreign investing. Foreign investors began buying commodities such as oil instead of U.S. Government bonds. As a result, the price of oil that the U.S. imports doubled in price. The rise in the price of oil increased the cost of producing goods used in construction.

Increased cost of production coupled with drastically reduced labor rates created a double squeeze on construction providers.

The contraction in the hospitality building segment is continuing while the economy slowly recovers. This segment is suffering, in particular, because of the lack of confidence in future market prospects. Hoteliers who have the capacity are consequently postponing investing in property while still holding out hopes of finding the perfect deal for pennies on the dollar. As the climate is still experiencing low investment levels, banks are holding the purse strings for construction lending.

As we have not seen a true recovery in the United States economy, construction projects will continue to be sparse.

The harsh reality is that construction service providers cannot expect to get out of this downward spiral any time soon, but the danger created by construction at drastically reduced rates is not that of contractors alone. There are risks to hiring labor forces on the “cheap”.

As many construction companies have been unable to maintain their overhead due to decreased prices, many have terminated their qualified work force. Pressure to hire unskilled labor forces at reduced wages has increased, along with the likelihood for use of illegal laborers. Any hindrance to the construction schedule, mistakes, or disruption to the operation of the hotel as a result of lessened performance standards could have major impact on revenues, construction budget, and potential legal ramifications.

Another hazard of this cycle to continue is the probability of default by the provider under contract. Annual bankruptcy filings by businesses in 2010 totaled 56,282, an increase nearly three times that of filings from 2006. We experienced a steady increase in volume of businesses filing Chapter 11 of one and a half times the quantity from the year prior since 2007, with a cap at 60,837 business filings in 2009 (American Bankruptcy Institute).

Albeit we have experienced a slow decline of businesses failing since 2009, the statistics demonstrate that many more will fold in the coming years. If businesses do not see relief in the economy soon, many more will be forced to close their doors. The risk within the hospitality industry to those tied up financially with them could be significant. Despite the slowly growing demand for construction as the economy begins its recovery and financing becomes more readily available, service providers may have created a rut that the will not soon be out of. As contractors have dramatically reduced their pricing due to the lessened demand and limited flow of cash for new projects, the expectation for inexpensive construction is set.

The light at the end of the tunnel is that the economy is in recovery and slowly, and with more caution, deals are being done. As distressed assets begin to change hands, renovation construction to change brand flags or reposition the property to increase market share potential or prior to sale are becoming more frequent.

As we entered the economic decline there was much talk of the coming wave of assets that would be available at extreme discounts due to the high levels of default. Although those prophecies were never realized, we have seen rates drop closer to fair market value and investing is improving.

Darwin’s “survival of the fittest” theory is applicable for hospitality construction providers, as the economic decline has certainly reduced the contractor pool. Those left standing are the best of the best. Most companies who survived the crisis had strong money management capabilities, little to no debt, and a solid and diverse client base. Additionally, they are those who sustained and wisely leveraged their business relationships, diversified and improved upon their offerings, and got creative about marketing to a changed industry. The result is a new breed of super servicers; more efficient, effective, and frugal than ever before.

Hospitality projects are on the rise, and little by little we will begin to see new development. In the meantime we should anticipate a wave of renovation construction projects to come as a result of a lot of deferred maintenance over recent years. Contractors may not be able to realize the margins they had in years past, but can hope for larger volumes of work. The benefit to clients is a newly positioned product at a great price!

As Project Director and Senior VP of Business Development, Julia Watson combines her knowledge of construction and her experience in business and relationship development, project management and coordination, estimating, and company-wide systems implementation to hospitality experts, FARROW Commercial, Inc. FARROW is a nationwide commercial construction company specializing in quality based, price sensitive, and production driven services to satisfy the demands of discerning core clients ranging from Resorts/Timeshares/Hotels/Motels to major and/or minor Commercial Tenant Improvements. Ms. Watson can be contacted at 916-474-5375 or julia@farrowcommercial.com Extended Bio...

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