Despite a challenging financing climate for new hotel construction, some Boston property owners are casting a vote of confidence in the city’s long-term lodging market prospects. Pictured is H.N. Gorin’s proposed 300-room hotel at 39 Stanhope St. in Back Bay. Image courtesy of Group One Architects
Successfully executing a hotel development project requires advanced navigation at every stage – from conception and financing to construction. Pursuing a development project has never been for the faint of heart, and investors in today’s market must contend with even more complexities than usual: the current high-interest rate environment, inflated cost of materials with long lead times and increased labor costs, including more onerous union agreements.
As a result, substantially fewer hotel development projects are moving forward, with many on an indefinite hold. Over the next five years, the nation’s new hotel supply is forecasted to grow at a rate that is just 60 percent of the lodging industry’s historical average growth rate. With new-build hotel development particularly difficult to pencil, more investors are considering adaptive re-use of underutilized assets, be it a repositioning of an existing hotel or conversion of another asset class to lodging use.
One asset type that has piqued the interest of developers for conversion into lodging use is office space. The ongoing shift towards remote and hybrid work has hit major metropolitan markets particularly hard, including Boston, with local office vacancies reaching nearly 20 percent in the first quarter of 2023.
Though acquisition costs may be more favorable, there are several considerations that can impact the viability of these conversions. For instance, the infrastructure and floor plate of office buildings do not always easily lend themselves to redevelopment into typical hotel guest rooms. The interior core and layout of many office buildings create long and deep guestrooms with limited natural light, which can pose a challenge in maximizing room count. There are also significant costs associated with installing required plumbing, HVAC and other mechanical systems, as well as complying with lodging-specific life safety codes.
As a result, many planned conversions will not materialize until office vacancies increase further and office building owners become more realistic with their sale price expectations in this new post-COVID environment.
High Costs of Construction Escalate
Additionally, with conversions, investors and developers will still have to deal with the material and labor issues muting new development, though to a lesser extent.
While material ordering and delivery lead times have improved with the strain on the supply chain having eased somewhat over the past six to 12 months, the actual costs of construction materials have continued to escalate.
Construction labor costs have yet to see enough projects put on hold to result in any meaningful reductions in the various sub-contractors’ pricing given their own challenges finding skilled labor and increasing wages needed to attract it, which has also resulted in developers having to pay increased overtime to keep projects on schedule.
With all these challenges, the capital needed to fund hotel projects has never been higher. Unfortunately, the heightened need for funding comes at a time when debt financing is substantially less available than in the past.
Interest rate hikes and the recent string of bank failures have resulted in an exodus of funds from regional banks and squeezed the lending capacity of many institutions that owners and developers have traditionally relied upon to capitalize their projects. In the times when debt financing has been secured, it has come at much higher interest rates, lower LTV ratios requiring more equity, and more stringent recourse and other guaranty requirements.
While many think interest rates will gradually fall by the end of 2023, the most recent Federal Reserve increases have brought interest rates up to a level not seen since the third quarter of 2007.
Derek Olsen
Non-Traditional Structures Rebalance Risks
With the challenges of obtaining funding from the more traditional channels, investors and developers have had to get more creative. One example is some recent transactions involving a lease structure sharing the risk between owner and operator whereby the operator locks into minimum annual lease payments to the owner but participates in revenues above pre-determined thresholds. With revenues per available room (RevPAR) surpassing pre-COVID levels in most markets in 2023 and continued growth expected in the coming years, the lease structure offers more potential upside for the operator while minimizing the hotel’s exposure in a downside scenario in the event growth does not materialize as anticipated.
Despite these headwinds, the hotels that do get built and acquisitions that get completed should perform well, considering new hotel supply is more tempered than in previous cycles with similarly growing room night demand and above-inflation room rate increases.
Rachel Cowley
Importantly, leisure demand remains solid and buoyed by returning group business and corporate travel, according to Smith Travel Research. In the top 25 metro markets, year-over-year first-quarter occupancy growth was 11.4 percent, with Boston one of the leaders in RevPAR growth over first-quarter 2022 levels at 35 percent, behind only San Francisco, Washington DC, New York, and Las Vegas.
With so many factors to consider in an ever-changing environment, looking for sound, expert advice is critical for hotel developers and owners alike. While capital markets are impacted more nationally, hotels have unique operating models that vary across markets and call for local experts to help guide developers and investors in making the most informed decisions possible.
Derek Olsen is managing director and executive vice president and Rachel Cowley is an associate at CHMWarnick, a provider of hotel asset management and owner advisory services.
