Four benchmarks for evaluating new hotel projects

John Petrovski

John Petrovski

by John Petrovski

The hospitality sector is in the sixth year of a bull run after the 2009-2010 economic downturn. Most markets across the country are enjoying record-high occupancies, while daily room rates and top-line revenue growth have been strong.

It’s been exciting times and all good news, but there’s more downside risk today than there was a few years ago. Now, greater deal selectivity is prudent, and the best developers and operators will outshine the competition.

In the midst of a boom market, it’s easy to believe that the market can only continue to grow. That may be leading some developers to be overly aggressive in entering new markets and pursuing new hotel developments. But considering that the typical upcycle for the hospitality industry is about three to five years, the current bull market is bound to run out of steam sooner rather than later.

Depending on the conditions specific to a particular market, developers could be better served by being conservative in their projections for the next two years and considering alternative strategies.

Timing is everything

A big risk with new construction is the 18-to-24-month gap between project start date and completion. If a developer is planning to launch a new project based on recent growth statistics, there’s a good chance that the hotel is going to open in market conditions that could be drastically different from what they are now.

Michael Watson, head of BMO Harris Bank’s Hotel Finance Group, points out that several markets that had a low risk of oversupply a few years ago, including Chicago, Nashville and Austin, have since begun to show signs of oversupply based on projects that were started in 2013 and 2014. That type of new supply has a negative impact on occupancy, which in turn puts a constraint on the ability to drive rates.

Of course, it’s tough to predict when a downturn will come. But it’s clear that valuations have peaked over the last 12 months in many markets, and we’ve recently seen a number of pending transactions break down prior to closing due to pricing concerns (i.e., buyers were fearful of overpaying for future revenue growth that could be delayed).

Assess the alternatives

Considering that we’re in the late innings of this industry upswing, Watson says developers should look at a few key indicators when evaluating new projects.

What are investors willing to pay on a per-key basis? Ideally, you want your purchase price to be less than the replacement cost for a new property. For example, an investor might be able to buy an existing property for $275,000 per key, whereas it would cost $325,000 per key to build the same hotel brand new.

What are the current capitalization rates? In general, cap rates are currently rising because growth expectations are slowing and investors are not willing to pay high multiples on in-place cash flows. Applying a cap rate of 7.5 to 8.5 percent is a reasonable “base case” for an average hotel in an average market today.

Year-over-year RevPAR growth. Over the last 20 years, the average rate of annual RevPAR growth across the United States has been 3 percent. In many markets, we’re now expecting growth of 1 to 3 percent on average for the next two to three years, with some markets outperforming and some markets lagging.

New supply levels. Anything more than 5 percent of current supply is a danger sign, but stronger markets are better able to absorb new supply.

Be ready to adapt

The savviest investors who have been through these cycles understand these risks and make their decisions accordingly.

Given the current market dynamics, the best opportunity for developers might be to buy — from a motivated seller — an existing property that could benefit from capital improvements, rebranding or repositioning. That way you eliminate the construction risk with its long delivery lead time, potential cost overruns and possible delays in delivery. You can also better manage your total per-key costs with an eye on keeping them below acceptable replacement costs.

Bull markets don’t last forever. But if you have a sound strategy in place that accounts for trends in your target market — especially supply-demand factors and expected RevPAR growth — you can put yourself in a position to thrive even when conditions change course and markets soften.

John Petrovski is senior vice president and managing director of U.S. commercial real estate for BMO Harris Bank.

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