Demand Slowdown and the Hotel Supply Conundrum / PKF

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. October 14, 2008

ATLANTA, GA, April 10, 2007. U.S. hotel owners continue to ride the wave of prosperity that has characterized the lodging industry since mid-2003. Twelve successive quarters of year-over-year demand growth, fueled by an expanding economy, has attracted a flow of debt and equity capital that has driven property values, and transaction activity, back to pre-9/11 levels in most markets. Of all the factors that have contributed to the robust health of the lodging industry, none has been more important than the unbalanced relationship between the above-average growth of demand and the minimal levels of new hotel construction. Now, however, according to a new study released by PKF Hospitality Research (PKF-HR), there is growing evidence that the imbalance may be coming to an end.

High Prices Begin to Impact Travel

Since 2003, demand has increased by 10.2 percent, while the net change in supply has been almost flat, which in turn has placed pricing power firmly in the hands of hotel managers. According to Smith Travel Research (STR), the average cost of renting a hotel room in the top 50 U.S. cities has increased by 23.0 percent during this time period. Consumers in many markets have begun to say "Enough!" and hotel occupancies have started to moderate as a result. STR also reports that annual demand levels in 12 of the top 24 U.S. markets (New Orleans is excluded from this list) actually declined in 2006. This trend has carried over into 2007, with first quarter industry-wide demand levels below their 2006 amounts.

So long as hotel construction volumes remain at historic lows, property owners who have been enjoying healthy profits had little to fear. However, PKF-HR's recently published study, The Hotel Supply Conundrum, which provides new insights to the current state of hotel development activity, suggests that the industry may be in for a wave of hotel construction.

In the report (available at www.pkfc.com/supplyconundrum), author Dr. Jack Corgel of Cornell University and Senior Advisor to PKF Hospitality Research, focuses on the variety of factors that have made the economic justification of lodging development extraordinarily difficult.

A unique combination of events led to dramatic increases in construction costs in recent years. High GDP growth rates in China and India pushed up prices of raw materials such as cement and metals. The expanding housing market also caused upward pressure on the prices of developable land, construction labor and materials. Add to the mix the large speculative premium that resulted from the rush of hedge funds into the commodities markets, and the developers' nightmare became complete.

Mark Woodworth, president of PKF-HR, notes that a select group of upscale and luxury developers have been able to close the gap between market values and replacement costs by incorporating residential units into their hotels. "We have also seen limited service hotel development in secondary and tertiary market areas where cost pressures have been less severe," Woodworth noted. But a review of the volume and period-to-period movement within the development pipeline tells the bigger story.

The Flow is a Trickle

The last time the U.S. lodging industry experienced a comparable period of strong demand growth with limited new construction was 1994 through 1996. This was followed by robust levels of domestic construction activity through the last half of the 1990's. During this period, according to data compiled by STR/Torto Wheaton Research and Dodge (STR/TWR/Dodge - see accompanying Table 1), total projects in the development pipeline averaged approximately 4,300 per year. On average, over 70 percent of these projects were either under construction (42.6 percent) or in the final planning (or bidding) stage (31.0 percent). By 2005, deteriorating industry fundamentals, followed by the aforementioned run-up in development costs, resulted in the decline of the total number of projects in the pipeline to approximately 3,000, with only 32.1 percent in the under-construction or final-planning stages.