The latest California hotel development survey showed a record-number of openings, but increasing construction costs, a complicated entitlement process and supply concerns cast some doubt on more record-setting years in the near future.
REPORT FROM THE U.S.—With a record 11,795 hotel rooms opened in 2019, there’s no doubt California hosts some of the most sought-after markets in the country. However, as the cycle continues on and new rooms keep coming online, concerns about market saturation grow.
The “California Hotel Development Survey 2019 Year-End” from Atlas Hospitality reports new rooms openings last year surpassed 2017’s record of 10,793 rooms. Along with the 92 hotels that opened in 2019, the state also had 212 hotels with 28,102 rooms under construction and another 1,199 hotels with 159,711 reported rooms in various stages of planning, representing a 7% year-over-year room count increase.
Many of California’s markets continue to see revenue per available room above the national average, Atlas President Alan Reay said. That continues to draw in hotel owners and developers hoping to take advantage of the demand.
However, the U.S. hotel industry is 10 years into its recovery, and those don’t last forever, he said. Some developers could be worried supply is growing as performance slows. At the same time, many people would have predicted last year that by now interest rates would have gone up and things would have slowed down more than they have, he said.
What’s in development?
The majority of owners and developers opening hotels in California are looking to build new properties as opposed to renovating older hotels, Reay said. There’s a 20% to 25% premium over existing product, but they know long term they’d have to invest a lot of capital into a hotel that’s 15 to 20 years old.
At least 70% of the new properties being built are higher-end, select-service hotels, he said.
Most of the properties will have flags from the major brands, such as Marriott International or Hilton, Reay said. It’s easier for them to get construction financing under one of these brands because lenders see all of the new supply coming in and want a dependable brand alongside a property in a good market with a good developer and good operator.
Hotel owners and developers in California are typically long-term holders who see the benefit of having a brand-new asset in a market, he said. On top of that, the tax burden on short-term capital gains is a good incentive to hold.
The current environment
Two trends in California that continue to affect hotel development are the increasing amount of time it takes to get a project entitled and the escalation of construction costs, said Corry Oakes, president and CEO of OTO Development, via email.
Over the last five years, hotel construction pricing has exploded in the major California markets, jumping in percentages by double digits each year, he said.
“The combination of increased construction activity, tariffs on materials, and a lack of recovery from the last recession in the number of people participating in the construction industry has created a perfect storm,” he said.
Developing hotels in California isn’t getting any easier, said Bob Olson, president and CEO at R.D. Olson Development. Construction costs continue to escalate, and that’s for all building types, not just hotels, he said. The process also becomes more complex as different markets add on regulations and complicate the entitlement process.
Developers around the state made a mad rush to get their plans to cities’ building departments for approvals before the end of the year because the state’s new building code was going into effect, Olson said. The new code will likely add another 5% onto construction costs, and that’s on top of the 4% to 8% construction costs increased over the past year. For a select-service property in the suburbs, the cost to build is about $200 to $250 a square foot while a concrete high-rise in an urban location is $300 to $400 a square foot, he said.
Olson said his company is well-versed in the development process in California’s coastal zone, but even so, it’s difficult to get a project going in an urban area. The California Environmental Quality Act requires countless studies on things like shade and shadow, traffic and groundwater issues. Sometimes the U.S. Army Corps of Engineers gets involved, and other times it’s the fishing and game department, he said.
“It goes on and on and on, and it is very, very difficult to get done,” Olson said. “It just continues to get more complicated, and construction costs continue to rise. The planning departments have so many other developments, they’re having a hard time handling the load on top of the continued new additional regulations.”
For the metropolitan areas where OTO Development focuses on development, such as San Francisco, Los Angeles and San Diego, it continues to see increasing challenges in moving a project through the entitlement process, Oakes said. Outside forces and a growing demand on city staff have made the process more cumbersome and time-consuming, causing the development timeline to grow and become more expensive, he said. The construction labor market is also constrained by the large number of projects in these markets.
“It’s challenging, but we continue to focus on these markets looking for the proverbial needle in a haystack,” he said. “It has become increasingly difficult to find deals that create returns that justify the risk and expense.”
Supply and pipeline concerns
Olson believes the environment in California calls for a pullback in new development. Many markets are reaching saturation levels where supply is exceeding demand.
R.D. Olson Development has a hotel in Pasadena that was the first hotel built there in the last four years, he said. Suddenly, there are three or four new hotels approved, under construction or just opened, he added.
The problem with developers is they are committed to a project that can take multiple years to get approved, and they’re committed to getting it done one way or another regardless of whether the demand is still there, he said.
Over the past 10 years, California has been able to absorb the new supply that opened during the recovery, Reay said. The state hasn’t reached the tipping point yet, but there are some warning signs.
While developers often delay or walk away from a project during the planning phases, there have been a number of projects that have experienced some problems during the construction phase, he said. For example, in the Coachella Valley and Palm Springs, there are about a half dozen hotel projects in various stages of construction in which the developers have stopped building.
“On the construction side, I would normally have said, you know, maybe 5% of those (will be abandoned), but we're starting to see if they haven't budgeted correctly, both from the developer/lender, then they're running into issues,” he said.