Hotel Industry Outlook: Jim Butler’s Top 10 for 2014

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By Jim Butler and the Global Hospitality Group®

Hotel Lawyers | Authors of www.HotelLawBlog.com

21 January 2014

Hotel Industry Outlook: Jim Butler’s Top 10 for 2014

by

Jim Butler | Chairman, JMBM’s Global Hospitality Group®

A lot of exciting things are happening in the hospitality industry as 2014 opens. Based upon more than $68 billion of hotel transactions, JMBM’s Global Hospitality Group® has made its “top 10” pick of the events, issues, trends, and developments that will have the biggest impact on the hotel industry.

1. 2013 will prove to be better-than-expected, but 2014 will get even better. Sunny times ahead.

Better-than-expected results for 2013 will lay a solid foundation for continued growth and profitability over the next several years. Supply growth will be only about .8% – well under the long-term average of 2%. Demand growth will exceed projections, probably reaching 2.2% to 2.4%. Most importantly, ADRs have been increasing at about 4.4%, bringing disproportionately greater profit straight to the bottom line. And finally, RevPAR growth will be somewhere in the range of 5.6% to 5.9%. The numbers for the upper end of the market segments are even better.

Depending upon whose numbers you select (STR, PKF and Pwc), 2014 just gets better. Supply growth will edge up to 1.1%. Demand will grow at somewhere between 2.1% to 3.1%. Occupancy growth will approach 2%. ADR growth will range up to 5.2%, with RevPAR growth between 6.0% and 7.2%. At the luxury end of the market, RevPAR growth is projected to grow at 8.3% in 2014.

These sound industry fundamentals are reinforced by the improving American economy. Recently revised GDP growth for the third quarter 2013 is at 4.1% — the strongest advance in nearly two years and only the third time the economy has expanded that quickly from one quarter to the next since 2006.

Although this is expected to moderate in the fourth quarter of 2013, GDP growth for 2014 is expected to be strong, accompanied by lower unemployment, increased consumer spending, more exports, revitalization of the home building industry and weaning the economy off of Fed bond purchases.

There is a remarkable relationship between growth in GDP and growth in employment on the one hand and the health of the hospitality industry on the other. The confluence of strong industry fundamentals and an improving economy signals a forecast of more sunny days ahead for some time to come.

2. This will be a great time to buy and sell hotels.

Transactional activity has been building and will continue to do so. In 2013, the industry will record about $18 billion of hotel transactions, compared to $13 billion in 2012 and $19 billion in 2011. This is not close to the frothy levels of $23 billion in 2005, $31 billion in 2006 and $27 billion in 2007. But it represents a vibrant, and probably more sustainable level of activity – well up from the $2 billion nadir of transactions in 2009 – without the risks of a bubble market.

We look for abundant capital, increasing foreign investment, and competitive financing from CMBS and other traditional debt sources to facilitate purchase and sale transactions to higher levels in 2014 and beyond. Increased leverage of cheap financing on existing hotels will also make it attractive for some owners to refinance their properties instead of selling, and thereby avoiding significant gains on sale for a few more years. Other owners will conclude that it is time to “cash out their chips” and let others face the new challenges that lie ahead.

3. Hotel values will increase for next 3-5 years.

In July 2013, Steve Rushmore announced at the NYU hotel conference that the HVS Value Index predicts all hotel markets in the United States will show value appreciation (at least) through 2016.

Miami, Oahu, New York City, San Francisco and West Palm Beach will lead the pack with price per key increases of $238,000, $210,000, $145,000, $139,000 and $80,000, respectively. At the time, HVS projected a 15% increase in value for 2014 and 9% for 2015. The significantly improved fundamentals of the hospitality industry, increased transactional activity, and readily available financing probably make these forecasts conservative.

In further support of the likely increase in hotel values for the near-term, STR reported that the weighted price per key for 2013 of $196,000 surpassed the prior peak of $174,000 reached in 2006. Rates are back to the levels prevailing in 2006 and 2007. And loan to value (LTV) ratios have reached approximately 73% in 2013, compared to 77% in 2007.

There are a number of important practical consequences of this predicted increase in hotel values, over the next several years. The prospect for value increase depends greatly upon the hotel market, market segment, and specific hotel property. To optimize investment results, market research and due diligence are critical.

Hotel value increases also create a sense of urgency to invest now before prices go up, or to sell now while the market is hot. Increased values (and corresponding higher prices) will also create more development opportunities, as it becomes skillfully cheaper to build a hotel than to buy one in more markets – always subject to the necessity of validating the fundamental feasibility of the development project.

4. Foreign investment will increase — particularly from China.

It has taken many years, but the “sleeping dragon” is really awakening. China is becoming a major factor in many dimensions of the global economy. The increase in China-based investment in the United States and elsewhere (along with the dramatic increase in Chinese tourism) is only beginning.

A large part of the publicity has gone to the EB-5 immigration investment, whereby a an expedited path to a green card is offered to foreign investors who make a minimum investment in the United States. Over the past three years, the Chinese have come to comprise 80% of the EB-5 visas, and their visa applications have just about used the 10,000 maximum number of EB-5 visas available annually. It is likely that the Chinese investment under this program will be a little over $2 billion for 2013. But this is just the tip of the iceberg compared to mainstream, non-EB-5 investment!

Anecdotally, the headlines are filled with stories of acquisitions by Chinese investors, ranging from homes, to one-off hotel or commercial property purchases, to landmark properties.

The Kiplinger Report projects that China’s foreign investment (globally) will exceed $1 trillion over the next 10 years. Increasingly, the United States is a focus for a portion of this Chinese foreign investment. Kiplinger estimates that by 2023, $15-$20 billion a year will be spent on buying US assets. To date, China’s current holdings in U.S. real estate, plants and operations total only about $54 billion. This is small compared to British holdings of more than $440 billion, but the Chinese investment will represent a significant and long-term factor in the US real estate markets.

In September 2013, Greenland Holding Group, a fortune 500 company, bought a large site in downtown Los Angeles for $1 billion – the biggest deal for Chinese developers in the US to date. They plan to build a hotel, office units, serviced residences and high-end homes.

The initial wave of Chinese investment has been led by wealthy individuals, some of the more than 700,000 high net worth individuals with more than 10 million yuan in disposable assets. These individuals, with average disposable assets of 31 million yuan, hold more than 22 trillion yuan in hand ready to be invested. Only now are the more institutional investors, large companies, banks, insurance companies and other government-sponsored businesses, beginning to get in on the direct foreign investment game.

Since China first encouraged domestic businesses to “go out” in 1999, Chinese outward foreign direct investment (FDI) has grown rapidly. The 2012 World Investment Report by the United Nations revealed that accumulated Chinese outward FDI was more than $366 billion by the end of 2011, with $65 billion in 2011 alone. Those numbers in the U.S. in 2012 were $27.9 billion and $6.7 billion respectively, according to the China Investment Monitor. They are expected to rise sharply and many observers believe that Chinese enterprises will become more aggressive in their outbound investment in the coming years.

Chinese investors continue to demonstrate a preference for real estate, including hotels. Many take comfort in an investment property that is operated by an internationally recognized brand.

5. New wave of hotel development.

A new wave of hotel development has already started. Why? The new development will be driven by pent-up demand accumulated during a long dry spell of the low-average construction of new hotel rooms, excellent prospects for the hospitality industry, increased demands by investors for hotel product, increasing hotel values that make it cheaper to build hotel rooms rather than buy existing ones and increasing availability of construction financing.

Rising hotel values and ADRs make new construction economically feasible. 2013 will show a 29% increase in rooms under construction – going to 86,000 from 67,000 in 2012. And in addition, the number of hotel rooms going into final planning will increase to 130,000 in 2013 from 100,000 in 2012. 66% of new rooms under construction are in the upscale and upper midscale segments (31,600 and 25,700 rooms, respectively) and select service is a big portion of these new rooms in the segments. Only 4400 rooms are being added to the luxury segment, where the difference between the cost to build and the cost to buy is greatest, but the financing challenges are also the greatest.

There are significant implications to this new wave of development. Customers will have greater choices as new product comes online. Competition will eventually limit ADR and profitability increases. The new product will create new opportunities for management agreements, franchise agreements, asset management, and many related professional services. The new product is likely to be “greener”, more technologically advanced (with the technology already “built-in”), and attractive to many customers who want to stay at the latest hotel. This will create new pressures on existing hotels to meet the competition both in terms of product quality, upgrades, and technology. While healthy in the long run, this will present special challenges to owners of existing product.

6. Construction financing will come back.

Construction financing is coming back. The analogy is to the first stages of financing recovery after the Great Recession. At first, the only financing available was $10 million and under. Then $25 million became a new hurdle, and only gradually was financing available for the biggest deals. Now it is very competitive for all existing hotels, and CMBS financing is approaching pre-peak levels of 2006 or even 2007.

Until now, construction financing has been most available for the lower-cost, select service hotels, with credit enhancements, brand support, municipal assistance, great sponsorship and lots of equity. But we see 2014 as an inflection year when smart lenders and CMBS investors will return to construction financing for higher yield. If the lenders and investors are really smart, they will make sure that they have loan officers or investment advisors who are experienced in construction lending which will help avoid many of the problems incurred in the past.

Construction financing is the last element necessary to fuel a significant development boom that will bring substantial new supply online in 2016 and 2017.

7. Labor issues will grow in number and importance.

While hotel industry ADRs and RevPARs are rising, alert operators and owners have become concerned that operating expense increases are outpacing revenue growth. They are scrambling to find ways to restrain operating expenses. Unfortunately, there is not much hotels can do about taxes, utilities and other fixed costs, but labor costs are potentially one of the most significant controllable costs of a hotel.

Industry experts have said it costs approximately 37% more to operate a particular hotel property as a union shop (rather than non-union). For this reason, developers, owners and operators will generally try to keep their hotel union free where that is possible. This also gives them more control and direct communication with their workforce.

For a number of reasons, however, it will be difficult for many hotels to remain union free. In some “union towns” it is virtually impossible to operate without a union. Many financing sources come from union funds or union-friendly sources which may insist that both the construction and operation of a new hotel use union workers. Many government officials seek to impose union-friendly restrictions as a condition for new entitlements or approvals, or condition for municipal financial support (such as transient occupancy, property and sales tax abatements or rebates). This is the quid pro quo payback for campaign contributions and support by unions that now want neutrality agreements (card check procedures), living wage agreements, and other union-supported mandates that will increase operating costs. Unfortunately, many developers report that the added cost of the union concessions more than offsets the financial benefits.

When faced with these pressures, it is critical for ownership and management to recognize that virtually all of these arrangements are negotiable. While it may be inevitable that a neutrality agreement must be signed to obtain necessary entitlements, the terms of that neutrality agreement can be as complex – and as critical to the success of the hotel – as the terms of a long-term franchise or management agreement. There is no “standard form” of agreement. Negotiated terms can create substantial value.

The same is true in negotiating renewals or amendments to existing collective bargaining agreements with the unions.

8. ADA compliance will become even more important.

More than 16,000 private lawsuits and Department of Justice enforcement actions have been brought under the Americans with Disabilities Act (ADA), and most of these in the last few years. Hotels, resorts, restaurants, sports facilities, spas, office, retail and other “places of public accommodation” are the principal target for these actions.

Many owners have been distracted by the pool lift requirements or focused on that issue alone. Others have taken false comfort in the fact they have not yet been sued or have settled an action brought by one plaintiff. ADA enforcement is an area where private and government litigants will continue to increase the enforcement efforts across an ever-broadening list of requirements. Now is the time for preventative action through a compliance review and assessment, and necessary alterations.

ADA compliance will have special impact on new development, and major renovations. Special rules apply to condo hotel developments where there is a strong legal trend to only count ADA units owned by the developer/owner, and not ADA units that have been sold to condominium buyers.

The ADA is not just about handicap parking spots or fixed pool lifts. It requires a path of accessibility throughout most properties, ADA compliant websites for visually or hearing impaired persons, written policies, procedures and training to deal with handicapped persons, and many other factors.

9. Mixed use projects – particularly with hotel elements – are making a big resurgence.

The advantages of mixed-use development were well-established in the last decade before the Great Recession. The economies of sharing certain costs and facilities, the enhanced value to end-users, and greater market appeal are significant.

The types of hotel mixed-use projects are continuing to expand. Originally, the simplest ones involved hotels with some residential complement, such as for-sale condominiums, condo hotel units, or single-family residences. More complex projects add retail, office, entertainment, sports and recreational facilities to the hotel/residential complements. In the last year, many of the largest shopping center owners in the country have picked up where they left off when the Great Recession hit. They are now adding hotels to their retail centers to obtain significant synergies.

Consumers increasingly want the live-work-play experience. They want to live where they work and shop, and shop where they live and work, etc. The marketing gurus all agree that today’s hotel customer is looking for an “experience”, not just a room. This kind of experience is most easily provided in a mixed-use environment, usually with strong lifestyle elements.

Golf has long been an attractive amenity for high-end residential product and hotels. The strong influx of Chinese and other Asian investors is putting greater emphasis on having golf as a part of a project, and we believe these interests will drive golf course acquisitions and development in 2014 and beyond.

Condo hotels are back!

Some advice for those embarking on a mixed-use project development: mixed-use projects are much more complex than single purpose developments – in the legal structure, documentation, financing, and operation. Be sure you have an experienced team to avoid significant pitfalls.

10. To brand or not to brand…

The importance of branding – or not branding – will reach a new peak. With each passing season, the brands make their management agreements and franchise agreements more onerous to owners and developers, increase their fees, and create ever new cost centers paid for by ownership. The question is not whether brands bring value to a hotel. In almost every instance they will. However, the question is whether the value they bring is worth the cost to the owner. Many owners and independent operators have concluded it is not worth the cost, except for “special situations” such as convention center hotels or large international resorts.

Nonetheless, lenders and investors love brands. The brands provide a sense of comfort, institutional validation and immediate recognition. The brands may also provide critical capital in development situations which is necessary to complete the capital stack. Thus, although it might be better for owners and developers in the medium-to-long term to operate without a brand, they will sign up for long-term branded management agreements and franchises in order to get their project done.

Others will fully explore alternatives such as soft brands and boutique or independent operation. Some will strive mightily to negotiate fairer arrangements with the brands. All should recognize that two of the most important things they can do for their hotel asset are (1) to choose the “right” brand and operator, and (2) to negotiate a management agreement that preserves a reasonable amount of value, control and flexibility.

It’s a good time to be in the hotel industry!

Hotel fundamentals are strong and all indicators point to an increase in transactions, development, and investment in 2014. Savvy hotel owners, developers, investors and capital providers will continue to rely on experienced advisors so that every deal adds optimum value to their properties and portfolios.

This article first appeared in HotelExecutive.com and is republished with their consent. HotelExecutive.com holds the copyright and this article cannot be republished without prior written consent.