Boston, the metro area and the rest of New England have enjoyed an excellent run for both occupancy and average daily rates over the past nine years. There doesn’t appear to be any reason for that not to continue, but a few very real issues are creeping into the business of renting hotel rooms and owners/managers need to focus. We are always concerned about new supply. Revenue trends are eagerly anticipated. But mundane issues that hit the P&L and therefore profitability are here and growing.
According to a presentation given by Mark Woodworth, head of lodging research for CBRE Hospitality Research at a recent Cornell/BU Hotel School event, hotel revenue is expected to remain positive for 2018 into 2020, but the rate of growth is grinding to a crawl at +/-2%. While interest rates increase by the quarter and labor costs increase every day. With the unemployment rate (3.7%) at its lowest in 49 years, available workers for positions such as housekeeping and culinary arts are very scarce. We are running out of workers.
Those of us with gray hair (mine is premature) like to blame the slacker Millennial’s for taking too much time off. Older Americans are staying in the workforce longer and that’s a good thing. Immigration policies that have yet to be reformed keep workers out and the lack of workers cause labor costs to rise. Amazon boosted everyone to $15 per hour. Those that were making $15 are being given raises.
When the top line continues to rise, especially over an extended period like the cycle we are in right now, owners get complacent. However, this situation is like a new house, with termites. The house looks great. But it is being eaten away from the inside. Labor costs and everything to do with personnel is increasing at a higher rate than revenues.
Supply in Boston has increased by 5.3% (STR) and we have some big increases coming on line in 2020 & 2021 when the economy is expected to slow down and growth is under 1%. The costs associated with construction have increased by double digits over the past five years. There isn’t a contractor in the business that isn’t looking for good help. Anyone that went to a “Tech/Trade School” and has spent four years in the workplace is laughing at the salaries of any kid graduating college with a Liberal Arts degree. The liberal arts graduates are encouraged to pick up a hammer!
The good part of this is that the thousands of hotel rooms that have been permitted across the region won’t get built in this cycle because the cost associated with their design and construction exceed what is considered feasible for a profitable hotel project. Add in the rise in interest rates and a reluctance for lenders to provide capital to new hotel construction and many projects will stall. I recently sat with a hotel developer who took a call during a meeting. The news given to him is that his 45 day old, “best estimate” for steel had increased by $3 million. Hotel owners that complain about Trump’s tariffs should be happy in a way, because the price increases in steal and other goods from China are causing a ripple effect throughout the supply chain. The cost of everything from steel to computer parts has risen and this will forestall new supply.
The transaction train has been chugging along. HREC presently has over 90 hotels listed for sale across the country. It is expected that sales will increase by 28% from 2017 to 2018. A record year. However, an increase in interest rates will raise the cost of funds for investors. This will force capitalization rates to increase. When that happens there is a lag of approximately six months for the market to absorb the negative reaction of those increased rates and the decrease in the value of hotel cash flow. A $2 million net operating income with an 8% cap rate applied equates to a $25 million value. At a 9% cap rate, that same $2 million, that the owner ground out, despite rising costs of goods and labor, is now worth $22.2 million. A loss of nearly $3 million. That’s a hard pill to swallow.
Rising interest rates and rising costs signal a good time to take chips off the table. Take the gains and roll it into a marijuana distribution facility. The hard work of owning and operating a hotel is getting harder each day. If owners were getting rewarded for their hard work it would make some sense. But hard work for diminishing returns is not a winning formula.
Cautious optimism for 2018 and 2019 is the prognosis for the industry. Or maybe we should call it High Times!
James O’Connell is principal, ISHC at HREC Investment Advisors in Boston.
Over the past 25 years, Jim O’Connell has earned a reputation for succeeding on the toughest assignments by assembling all of the moving pieces within a transaction that has stretched to both coasts.
He gained his national contact base while advising workout professionals and managing the ORE hotel portfolio of the Bank of New England/RECOLL Management Corp.
O’Connell has represented public companies, private equity funds and high net worth individuals across the country and is known for having completed more hotel transaction in the region than any other broker.
O’Connell is a graduate of Massachusetts Maritime Academy.
