Hotel developers are pushing ahead with new construction projects, despite feeling the sting of rapidly rising labor costs.
REPORT FROM THE U.S.—Hotel owners and developers throughout the United States are finding it a good deal pricier to build new properties and renovate existing hotels, largely due to a pronounced shortage of skilled labor that’s sending costs higher and higher.
Still, despite the challenges of new-hotel construction, the right deals under the right conditions can happen, particularly for owners and developers savvy about lending, branding and weighing all their options.
A diminished labor pool
Sources explained that the labor pool within the construction trades has notably shifted over the past decade. Many tradespeople left the business during the 2008 recession, when work was scarce, and never returned. Young workers haven’t rushed in to fill the void, so those tradespeople who remained often have their pick of projects, especially amid a rebuilding boom in the wake of a series of recent natural disasters.
“I’m in the process of building a hotel right now, and construction costs are extremely high. There’s a significant lack of labor—good labor, anyway,” said Rick Takach, chairman and CEO of Vesta Hospitality. “I don’t see the problem getting any better, either. It’s the time of the contractor, no doubt about it.”
Hoteliers everywhere are echoing Takach’s sentiments about the current construction outlook in the industry. Although labor issues vary somewhat according to market/geographic location, the increasing difficulty of enlisting skilled workers for both construction and renovation projects seems more universally felt across the industry.
“We’re seeing a labor shortage, and it’s really most prevalent in the skilled trades,” said Mike Zimmerman, VP of development for The Olympia Companies. “By that I mean plumbers, mechanical contractors, electricians and fire alarm contractors—the people who need to go to training school in order to do what they’re doing. There was an enormous gap in the skills development in this country during the recession, where people who were in the industry had to leave to find work. Construction didn’t look like a good place to be, because there wasn’t lending happening, so there wasn’t construction happening. So people didn’t pursue that as a career choice.”
The impact of that widespread occupational shift is being felt now. If developers can manage to find builders who fit the bill, the prices for projects are increasing considerably. Between local construction projects and massive post-hurricane rebuilding efforts in places like Houston and South Florida, as well as in parts of California affected by fires and mudslides, experienced tradesmen are now commanding top dollar for their work.
“Construction prices are skyrocketing; they’re not rising,” said Mark LeBlanc, EVP of development and acquisitions at Interstate Hotels & Resorts. “There is some variance as to the part of the country you’re in, but the story’s going to be similar everywhere. With the natural disaster we had last year with Hurricane Harvey, and the fires in California, the demand on materials and subcontractors has just increased significantly. If you can get somebody to bid on your project, it’s going to be more expensive than it was a year ago; I’m guessing it will be at least a 20% increase over last year.”
However, sources agreed that finding a great project manager with the right experience saves time and money in the long run.
A material issue
While currently not quite as worrisome as labor, the costs of materials have also grown appreciably, sources said. A certain amount of cost creep is to be expected, they said, but as with labor, this is exacerbated by the extensive rebuilding going on in disaster-affected parts of the country, which is boosting demand for essential supplies.
“Generally, what we find is when the volume of construction activity increases, it tends to impact most trades and most materials,” said Rick Lloyd, VP of cost and risk management for MGAC, a construction owner advocacy, project management and cost-consulting firm. “We’re seeing pressure on construction prices for mechanical, electrical and plumbing, curtain walls, elevators, and drywall, and we expect other trades to follow suit, so it’s really across the board.”
Lloyd said he expects present conditions to continue for another year or two at least, until construction activity naturally wanes as an inevitable part of the development cycle. That will put a damper on expanding costs, even if it’s just a temporary respite, he said.
“Most of the country is in a fairly significant growth and expansion mode right now when it comes to construction,” Lloyd said. “The reality is at some point costs will level off, but everyone has their own crystal ball in terms of when that might be. In my opinion, over the next 12 to 24 months I’d expect a similar level of activity and maybe still some increase in the overall volume of construction work, but two years beyond it may well start to level off and maybe stay that way for some period of time after that.”
The capital cost crunch
The other crucial factor that seems to perpetually affect hotel construction projects is the availability of financing, and the prevailing cost of obtaining capital. Sources generally agreed that financing is obtainable these days for worthy projects by reputable developers, but they said the cost and requirements of borrowing—and participation of lenders—can vary greatly from one borrower, market and project to the next.
The choice of brand for the intended property can have significant bearing on financing construction deals, sources said. While capital may be readily available for recognized hotel brands—which are considered relatively “safe” investments—funding requirements may be more stringent for independent projects where a franchise flag isn’t in place.
“There is financing out there, particularly for the (recognizable brands), because banks are comfortable with that product,” LeBlanc said. “The experienced developers aren’t having a hard time getting their stuff financed. But, if you’re going to do a high-end independent and you don’t have sponsorship, you’ll have a very tough time.”
In tricky financing situations, developers are often forced to accept less-than-prime lending rates to get deals done. That leads to higher costs of capital, which, combined with spiking labor and materials costs, can make it more difficult to justify a project on a pro forma basis.
“I’ve seen some of our partners and other developers have to pay quite a lot in cost in terms of interest rates,” Zimmerman said. “I’ve seen some people go with unconventional financing products that do drive up (costs), particularly that construction interest, significantly.”
Think outside the box
In response to the construction cost dilemma, some developers are changing the nature of the projects they undertake. For example, a switch in focus from ground-up construction to more renovations and adaptive-reuse projects is often seen as more profitable—and both cost and culturally sensible.
“A lot of us have been forced, in multiple industries, to really take a step back and look at the resources we have—the available resources, the shortages—and really approach things a little differently,” Bill Wilhelm, president of R.D. Olson Construction, said. “For example, (we may look at) going from ground-up to adaptive reuse, seeing where we can cut costs and minimizing some of the trades you might deal with in a different environment. Over the last 18 months or so, we’ve seen the continued increase of major renovations and adaptive reuse-type properties.”
Otherwise, with construction costs still on the rise and under sustained pricing pressure in seemingly every expense category, sources said the obvious outcome is a ceiling on supply growth. Projects that might have been feasible in the past simply can’t be justified now due to rising costs and tightening profit margins, they said.
It’s an effect that’s already becoming visible.
Despite the relatively active construction pipeline in the U.S. at the moment, overall supply growth numbers forecasted for the industry in 2018 and 2019 remain modest. STR (parent company of HNN) and others are calling for new supply growth in the ballpark of 2% overall this year and next, and mostly concentrated in popular, profit-intensive sectors like upper-midscale and upscale select-service brands.
Some hoteliers question if, in the end, this current lodging cycle will be dictated not by consumer demand levels or debt markets, but rather the ongoing battle to minimize construction costs and find projects that pencil out.
“This time, I’m wondering if the cycle’s a little different. It’s not lack of financing ability keeping supply growth down; I think people are having a hard time building due to construction costs,” Takach said. “This might be the first time I’ve ever seen where we might be moderated a little bit in supply growth, just because building is very difficult, and sometimes, with these costs the way they are, it doesn’t make financial sense to build your project. The return’s just not there.”