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Construction costs up – Impact on Hotel Supply?

I recently read that the construction price index has gone up following news of the burgeoning CRE marketplace.

http://nreionline.com/construction/cre-rebound-sparks-higher-construction-costs

As all in the development community know quite well, the Turner Construction Index went up between 2004 and 2008 to ridiculous levels of increase. That basically followed CRE trends which were equally ridiculous and resulted in what we now call The great recession of 2008/2009.

Around the middle of 2008, there was substantial correction to the construction index and it dropped for a couple of years. Now, while the construction costs haven’t gone up to mid 2008 levels nor are the increases a real concern, but costs are rising now and are back up to 4th quarter of 2007 levels. The index is rising at a clip higher than inflation (4.3% increase in 2013) and is expected to go much higher.

Getting back to costs, ENR shows a more modest annual increase in their construction index shown below vs Turner Construction:

ENR Index TurnerConstructionIndex

Hotel Development Tidbit: A record number of new properties came online in 2008 (1,341 Projects/ 154,258 Rooms – according to Lodging Econometrics) despite tremendous construction cost increases around that time. I don’t believe we will ever reach that historic level in the next few years nor will the indices fluctuate as much.

So hard costs for hotels are bound to increase and will cost more to build as we move along. Replacement cost will be a consideration in the transaction velocity of hotels in all segments. So how does this cost increase impact the supply side of new hotel development? Is this going to deter hotel development? Here is Lodging Econometrics’ projected hotel construction pipeline:

LE Hotel Pipline

Now as we all know, STR and other analytics’ providers are very clear about demand for rooms outpacing supply. So, if rising construction costs even marginally decelerate development (at least the start next 12 months and the early planning projects may be affected), then is it fair to assume demand will continue to outpace supply? If so, how does it impact exit cap rates and sales price for hotels?  Is it fair to surmise that moving forward as replacement costs go up, and the supply/demand gap increases, transaction velocity of existing hotels increase? I believe so.

The logical expectation then would be that compression of cap rates are going to occur more rapidly. Data shows that cap rates are somewhat steady right now without too much movement. Also, this would give existing hotel owners a much needed respite with added equity.

Over the next couple of years, sale of properties and consolidation of hotel portfolios would make the most sense based on several variables such as franchise length remaining, CapEX requirements, entry cap rates, desired Yield, etc. However, the fact remains that a profit making window of opportunity for hotel owners may be on the horizon.

After what the industry went through over the last recession and economic downturn, I don’t think it is fair to expect a CRE boom. But, I do believe we are coming upon a climate of increased transactions in the hotel space with one caveat – Lending availability and ease of procurement. The banking industry has always been an animal of opportunity, and hopefully it doesn’t miss this one.

My sense is that with improving market fundamentals, capital will become available, but, with increased scrutiny.

Here are some recent transactions in the Mid-Atlantic region in the months of Dec 2013 and Jan 2014 the largest transaction being the Philadelphia Marriott Downtown for $303.4 million purchased by the joint venture partnership of Oaktree (Equity Fund) and Clearview Hotel Capital LLC (Private) and sold by Host Hotels & Resorts :

RCA Transactions Dec-Jan

Thanks for you time. Please call me or email me if you have any specific questions.

Vikram Antin | Managing Director

Sperry Van Ness | AREAS
3454 Ellicott Center Dr, Suite # 102 | Ellicott City, MD 21043
Phone 410.690.3335 | Fax 410.461.3336 | Cell 443.538.1224
vantin@svn.com