Will The Current Hotel Boom Turn To A Bust?

BY JOHN GORDON
Gordon/Rood Hospitality Consulting

A 400-room hotel at the state convention center. A 300-room property at SeaTac Airport. An upscale hotel on the Seattle waterfront. Lodging for extended stays near Seattle Center.

These are not stale proposals from the go-go years of the 1980s. These projects, and many others, are on the drawing boards today, and a significant number will be up and running within three to five years. Several new hotels already have opened, including the WestCoast Paramount and Cavanaugh's (both located in downtown Seattle), and the Hampton Inn near Seattle Center.

What is the source of this revived interest in building hotels? What are the likely consequences of development? Why is it happening now?

Cycles of development

The first thing to understand about hotel development is that it tends to occur in clusters. A market may go for several years with little or no construction, due either to low demand or a lack of available capital. During these years, if the area is experiencing growth in population and employment, lodging demand will gradually increase, and hotel occupancy will rise.

At some point, market conditions become strong enough to attract new development. During this period, it may seem that every block is sprouting a new hotel. The rush of new construction occurs because everyone is looking at the same positive market data, and because developers and lenders rarely consider the impact of other proposed projects. As a result, the supply of

The risk of overbuilding is in concentrating new supply and excessive developments of certain property types.

new rooms quickly outstrips any marginal increase in market demand, and the average occupancy rate in the market declines.

In a typical urban area, hotel market occupancy will hover between 65 and 70 percent, though individual properties will perform above and below this average. When occupancy is below 65 percent, little new construction will take place. A market occupancy rate above 70 percent is considered good; a rate above 75 percent is considered extraordinary.

The Seattle experience

In the Seattle market, the peaks and valleys of performance have been more severe than in many other U.S. markets. During the 1960s, the lodging market expanded rapidly, boosted by a World's Fair and the Boeing boom. In the 1970's, when the boom turned to bust, Boeing engineers weren't the only ones who cooled their jets: hotel development slowed to a crawl.

The perception of Seattle as a weak lodging market far outlasted the reality. Demand for rooms grew steadily through the decade. By 1980, county-wide occupancy for upscale and midprice properties was approaching 73 percent. This market included over 8,000 guest rooms in 45 hotels and motels, and accommodated nearly 2.2 million room nights of lodging demand.

When they finally recognized the opportunity, developers and lenders moved rapidly, adding over 4,000 new rooms in King County in a four-year period. By 1983, demand had risen to 2.4 million room nights, but the surge in capacity had dragged market occupancy down to 58.9 percent. It would be five years before the new rooms were fully absorbed into the market.

The flow of capital

The second factor affecting the pattern of hotel development is the availability of capital. While market conditions are measured on a local or regional basis, the financing decisions of major institutional lenders often are based on national trends. If lodging is perceived as a poor investment in general, capital does not flow even to the strongest of markets.

By 1988, county-wide lodging demand had ballooned to 3.4 million room nights, and market occupancy exceeded 70 percent. During the next five years, there was a trickle of new development, consisting mostly of small to mid-size properties in suburban settings. Financing was not generally available for large-scale projects, most of which were put on indefinite hold.

With occupancy at 70 percent, why weren't more projects undertaken? The answer lies not in our local market, but in markets across the country. For many cities, the hotel building boom, and subsequent dip in occupancy, stretched into the late 1980s. Many of these markets were in deep decline even as Seattle hotels were recovering.

By 1991, the accepted wisdom among major lenders was that hotels were a bad investment regardless of location, an attitude which prevailed for several years. It was only in 1994, when the national occupancy rate grew to over 70 percent, that the lending community returned en masse to hotels. By that time, King County hotel occupancy was over 72 percent, and climbing.

In 1996, the market included more than 17,000 rooms, demand was over 4.7 million room nights, and occupancy was 76 percent. This makes the Seattle lodging market one of the strongest in the nation, and one of the most likely to attract new development.

The coming boom

Will all the new projects lead to an oversupply? Probably not, for three reasons.

First, the market presently has room to absorb new rooms. In 1996, the existing hotels accommodated over 4.7 million room nights, with market occupancy at 76 percent. At that level of demand, a more typical occupancy rate of 70 percent would have been achieved with 18,550 rooms, or about 1,200 more rooms than were operating at the close of the year.

Second, county-wide lodging demand has been on the rise for nearly two decades, with annual increases generally exceeding 100,000 room nights. At an occupancy rate of 70 percent, continuation of this growth would support development of at least 400 new rooms per year.

Third, while capital is once again available for lodging development, lenders and investors have not entirely forgotten the lessons of the past. Projects generally require a greater equity contribution, and more attention is being paid to market conditions. These precautions should help to weed out some of the proposals.

All of this suggests that the county should be able to absorb about 2,400 new hotel rooms during the next three years. At that level of development, market occupancy should decline to about 70 percent, an acceptable (if no longer spectacular) level. If the number of new rooms developed is significantly higher, the impact on market occupancy will be more severe.

Avoiding a bust

The real potential for overbuilding does not lie at the county level. It lies in the risk of localized concentrations of new supply, and in excessive development of certain property types.

The King County lodging market is made up of dozens of small markets, clusters of hotels which compete with each other on the basis of location, facilities, and service. If all of the new development were to be concentrated in one or two of these locations, hotels in those submarkets could face declining occupancy and depressed room prices, even while the county as a whole was reporting strong performance.

Similarly, if all of the new hotels are of the same type, or are oriented toward a certain segment of lodging demand, that portion of the market could be oversupplied. For example, while there is presently a great deal of interest in developing extended stay hotels, the real depth of that market is unknown.

What can a developer or lender do to guard against overbuilding?

• Understand the pattern of demand in your specific competitive market. Is the current rate of occupancy abnormally high? Has demand been growing from year to year, or has it remained static? Is further growth anticipated? How soon can new rooms be absorbed?

• Take into account the impact of other potential additions to supply. How many hotels are proposed for development in the submarket? What will be the size, type and quality? What is the likelihood of each development?

• Be realistic as to the eventual competitive position of your property? Do you expect your hotel to attract new demand into the market, or to take demand from the existing hotels? Are those hotels likely to respond with price competition or stronger marketing efforts? How would their response affect your room prices and eventual bottom line?

The best advice for developers and lenders is easy to spot. It is usually posted in front of each construction site, accompanied by a flashing yellow light. The message: "Proceed With Caution."

John Gordon is a principal in Gordon/Rood Hospitality Consulting of Bellevue which conducts hotel appraisals and market analysis.