Record Development Pace Fuels California Supply Worries
California again proves to be a popular state for hotel development, but those in the industry are keeping a watchful eye on the amount of new supply coming in.
By Bryan Wroten
REPORT FROM THE U.S.—The latest California Hotel Development Survey by Atlas Hospitality Group shows the Golden State continues to attract record amounts of new development, but that high is tinged with concerns about overbuilding in some areas.
Developers finished construction on 38 new hotels last year in California, representing 5,572 new rooms, according to the survey. There were an additional 112 hotels with 17,623 rooms under construction, an 11% year-over-year increase from 2015. Beyond that, there are 679 hotels in the state with 102,821 rooms in other stages of planning, a 39% year-over-year increase in room count.
Looking at the development pipeline, Alan Reay, president of Atlas Hospitality Group, said he expects 2017 will surpass 2016 in terms of hotels opening and under construction. If the economy continues to grow and business is good, the markets will absorb the new rooms, he said. An increase in interest rates and an economic slowdown would have a dampening effect, he said.
One possibly ominous sign Reay pointed out was a striking similarity between the most recent survey and the one conducted in 2007. The survey of 2007 heading into 2008 has almost the same number of hotels either opened or under construction as reported in the 2016 survey, he said.
Though the counts are close, he doesn’t believe it’s an indication the industry is headed for a recession similar to that of 2008 and 2009. California markets are still seeing strong increases in revenue per available room brought on by increases in average daily rate, and there’s still strong interest from lenders in hotel construction.
At some point, the new construction will have an impact on revenue per available room because it’s adding a substantial amount of new rooms, he said, and that’s particularly true for areas without high barriers to entry. Markets like San Francisco, which is notoriously hard to break into, continue to enjoy strong demand and are likely insulated from downturns.
“The secondary and tertiary markets are where developers are adding more rooms,” he said. “They could have issues with overbuilding.”
New versus existing
New hotels will always win against older properties, said Bob Olson, president of RD Olson Development. He believes the problem isn’t that California markets are overbuilt. Instead, the markets are under-demolished, and older hotels always struggle against new supply.
Many hotels are decades old, he said, and it can be too difficult to upgrade them to meet modern standards, especially if they have and low ceilings or small guest bathrooms, public spaces and meeting rooms. Even when possible, renovations to reposition such properties are often expensive. Owners of old, obsolete hotels have to think about what alternatives they have for their current use.
“If you’re in a strong hotel market, the only way … to compete is by price,” he said. “There’s always room for a lower price point, but it’s difficult to compete against new hotels and their design. There are better facilities today for today’s travelers, as opposed to 40 and 50 years ago with different travelers and their expectations.”
The high value of California hotels has helped development in a couple of ways, said Robert Green Jr., president and CEO of The Robert Green Company. For one, it shows the overall market is strong and can generate high residual values. He said it also reveals new builds are less expensive than buying existing properties.
“I think the fact that acquiring hotel assets in California has been so competitive—though prices have tapered now, but they escalated the last 3 years—helps prove up the quality of the market and strength, especially if you have a really great product,” he said.
“History hasn’t taught us a lot,” Atlas’ Reay said. “It seems to be when the market is strong, everyone goes to build at the same time. Therein lies the issue.”
For developers today, he said, there are critical points to consider before starting a project: the strength of the brand, the costs going into the deal, the likelihood of new competition entering the market and the financing structure.
“It all comes back to the lenders,” he said.
Developers don’t talk very well with each other, Olson said. When a market has the right conditions, he said, everyone runs to get a product built and suddenly there are three new hotels going in instead of none.
His company is as guilty as anyone, he said. RD Olson is opening a new full-service Marriott in Irvine in a part of the city with a lot of new growth, he said. There’s 2.5 million square feet of office space opening before the hotel opens, he said, which is a good sign for the new property. However, there’s also a good amount of new supply either opened, soon to open or opening within the next two years.
“It’ll be interesting to see how it plays out three years from now,” he said. “Developers, by our very nature, have to be optimistic; otherwise, we would never build anything. Cautiously optimistic is the word around our shop these days.”
The industry has become more self-regulating, Green said. Investors and lenders are selective, he said, and they’re reticent to be aggressive in hospitality because the industry is so cyclical.
“We’ve learned some tough lessons,” he said about his company. “It’s good for our business. It will keep out projects that don’t make sense and just increase the inventory and drive revenue for the rest of the market down. Because the more inventory there is, as demand goes down, RevPAR goes down.”
What to watch for
Olson said developers should look for markets with multiple demand generators for corporate, leisure and governmental travel because those with just one or two demand generators tend to have higher RevPAR volatility.
“If you’re going to build just in a corporate park with no leisure around, be prepared, because when corporate travel cuts back, there’s nothing else you’re hitting on,” he said.
Developers also should weigh their potential projects against what’s already in the market, he said.
“If you’ve got a market with 15 limited-service hotels in existence, and you want to add another limited-service hotel, you have to think about that,” he said. “If the market has a significant number of four-star or full-service hotels, you can add a limited-service and it makes sense.”
Markets like San Francisco, parts of Los Angeles, Silicon Valley and coastal areas have high barriers to entry, giving them a stronger chance at success, Green said.
“We’re pretty picky about where we build,” he said. “We’re not trying to get into compromised markets or those without strong demand.”
California, by its nature, does well because it’s difficult to get entitlements, Olson said, and the costs are significantly higher than anywhere else in the U.S. Hotels have to follow tougher building standards to withstand earthquakes, as well as comply with higher Americans with Disabilities Act standards than in other states. Many municipalities require union construction, which increases costs.
“It’s a dynamic market,” he said. “That has cut into the supply compared to the rest of the country. That’s why you have supply growth. There still are markets friendly to developers, but they’re getting overbuilt now.”