Costs high, but can be worth the risk
 
Costs high, but can be worth the risk
02 MAY 2016 7:49 AM

While land and construction costs are high, they’re still manageable in most parts of the country, according to hotel owners. With supply and demand levels still in check, the rewards of hotel development still are largely worth the risk.

REPORT FROM THE U.S.—Land and construction costs are going up overall, which shouldn’t be a surprise, considering the point in the lodging cycle today. As with any real estate class, these costs tend to increase in the good times as competition heats up, but then stabilize or even drop during the bad times.

When it comes to land costs, the price developers are prepared to pay depends on the return they expect to earn from building on it, given the health of the market going forward, according to Gerry Chase, president and COO of New Castle Hotels & Resorts.

“Clearly, no one wants to overpay, but for a good site that will drive demand and higher (average daily rate), a steep price isn’t necessarily a bad thing in this market,” Chase said. “We think of the cost as relative to the potential risk and reward. If there are opportunities in the future because of this deal, the reward may well be worth the risk.”

For example, the popularity of the dual-brand concept is being driven, in part, by sky-high land costs, especially in high-barrier-to-entry downtown markets, where available land is at a premium. (See also: “2015 Development Activity By Location” on page 5.) Considering the cost per acre, Chase noted, it may not be the best idea to build a single brand, 300-room hotel.

“Rather, the more prudent decision might be to go with a dual-brand strategy and include two brands, roughly splitting the key count,” he said.

Meanwhile, other real estate classes are thriving.

“There’s always a debate about the highest and best use of a piece of land. Right now, multi-family is especially strong in many markets, so you have those developers attempting what amounts to a land grab,” said Bill DeForrest, president and CEO of Spire Hospitality, which is part of real estate investor and developer AWH Partners.

“They may be more bullish and, therefore, prepared to pay a hefty premium for a site, well beyond what seems to make sense from the standpoint of hotel operations,” he said.

The same dynamic is at work on the construction front. In a market like Atlanta, two new sports stadiums are under development and a number of retail projects are going forward. In addition, multiple multi-family developments are breaking ground.

“As a result, qualified general contractors and sub-contractors are extremely busy, which drives up costs because you have to pay more for the best ones,” said Mary Beth Cutshall, SVP of acquisitions and business development for Hospitality Ventures Management Group.

Be sure you’ve planned your designs carefully and kept your cost projections tight, Cutshall added.
“Build as much time as you can into the pre-construction schedule before a shovel ever hits the dirt,” she said.

Construction costs trends
How much are construction costs rising? In the Tulsa, Oklahoma, market, Steve Ehrhardt, owner of Ehrhardt Properties, has seen construction costs rise 4% to 5% in the past year, which he describes as “still within the realm of workable.” Developers in other markets cite increases of 10% to 15%.

In the Dallas market, costs also continue to rise, but the level of increase has stabilized. Back in 2014, Perry Molubhoy, CEO of Atlantic Hotels Group, was seeing quotes 20% to 25% higher than anticipated.

“Prices were fluctuating widely,” Molubhoy said. “We had to go back to our lender on one project, redo the loan application, get new appraisals to justify the extra costs and refinance.”
Fast-forward two years, and construction costs aren’t fluctuating as dramatically, according to Molubhoy.

“As for materials, suppliers who wanted to raise their prices may have already done so,” he said.

At the same time, unexpected shortages of key materials such as concrete and sheetrock can play havoc with construction timetables. As stockpiles of these materials start to diminish, prices for remaining supplies skyrocket, putting further pressure on project budgets already under stress.

The more specialized the project, however, the more demanding the construction skill set and the pricier it gets. Take historic adaptive reuse as an example, according to Mitul Patel, COO at Peachtree Hotel Group.

“Working with experienced workers, you have assurances they know what they’re doing and there’s greater likelihood the project will come in on time and on budget,” he said. “The downside: The cost is significantly higher.”

Plus, ultimately experience is no assurance.

“Contractors can claim to be experts, based on the historic projects they’ve done,” Patel said. “But each project is different. Charge orders and cost overruns seem to be the norm, rather than the exception.”

Nor does the fallout necessarily end there.

“Your investors can start getting nervous and it can hinder the relationship when you approach them the next time,” he said.

To some degree, rising construction costs are inevitable—and in a larger sense not always a negative, according to Mark Crisci, principal and CIO of Azul Hospitality Group, a third-party manager that advises its clients through the construction process.

“Owners and developers are always trying to make their projects better, whether from the standpoint of design, (furniture, fixtures and equipment) or technology,” Crisci said. “The more state-of-the-art these advances, the better positioned the hotel will be in the marketplace.

“Especially in robust urban markets, these upgrades, taken together, can provide a form of competitive advantage. They simply cost more. And there’s no question the best thing to do is incorporate them into the building during construction.”

The overbuilding question
Any discussion about construction in the hotel industry, whether ground-up or adaptive reuse, invariably raises concerns about overbuilding. Over the years, the industry has a history of overbuilding in the good times to the point where supply growth overwhelms the growth in demand, triggering a cyclical downturn.

STR’s pipeline report for March reported 1,201 projects under construction in the U.S., accounting for 153,345 rooms. This represents a 21.5% increase compared to March 2015. But the steep jump didn’t set off any alarms since almost 50 percent of the new rooms are being built in the top 25 markets. As STR’s SVP for operations Bobby Bowers noted that “the top markets are big demand generators,” and in most cases they can absorb the new inventory.

As of February, 67% of rooms under construction in the U.S. were in the upscale and upper midscale industry tiers.

STR’s current 2016 forecast shows supply growth increasing 1.7% for the year, compared to 2015, with demand growing 2.3%, well within comfort levels. For 2017, the forecast indicates supply growth accelerating to 1.9%, compared to prior year, while demand growth starts to slow to 2.1%.

For as valuable as nationwide numbers are, by necessity they paint the picture with a broad brush. Individual markets, after all, have their own supply and demand dynamics.

For developers concerned they’re bringing too much supply into a market, Atlantic Hotels Group’s Molubhoy recommends proactively monitoring new demand generators coming into the area over the mid to long term. They should be able to absorb any spike in new inventory.

“We track the supply-demand ratio closely to make sure we’re contributing to the overall growth of the market,” he said. “Should the market slow down, we want to be sure we draw down our efforts accordingly.”

In this regard, Peachtree Hotel Group’s Patel noted that a sign on his office wall reads, “All Markets Aren’t Created Equal.” In certain markets, he’s beginning to see lenders starting to tighten up financing for new construction.

“So there are going to be fewer projects coming out of the ground,” Patel said.

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