By Alicia Hoisington
Urban development has been booming of late, with many of the top 25 markets in the United States poised for exponential growth. According to STR, the top five markets in the majors in terms of rooms in the pipeline include:
- New York City;
- Los Angeles/Long Beach; and
But what’s the draw for developers when it comes to these urban markets?
It’s a combination of things, according to Peter Nichols, vice president and national director of Marcus & Millichap’s National Hospitality Group.
“The lending community has seen sort of a flight to safety – in the perceived safety – in a major metro like a New York, as an example,” he says. “It’s got the highest percentage of new development underway because it’s such a strong market.”
He cites high occupancies in New York City, running in the mid to upper 80-percent range, as well as the market enjoying some of the highest average daily rates.
Bruce Ford, senior vice president and director of global business development at Lodging Econometrics, says the No.-1 reason developers look to urban markets is because of rate.
“When you get into this time in the cycle when it’s cheaper to build than buy, developers are attracted to the highest rate markets,” he says.
Urban markets also are safe due to their mix of demand drivers, sources say.
“There’s a safety in that it’s New York. It’s Miami. It’s Denver. It’s not Peoria, Illinois,” Nichols says. “No knock against Caterpillar or the folks in Peoria, but it’s not what you would call a major metropolitan market.”
He gives the example that if Caterpillar were to leave Peoria, its demand driver would exit with it, leaving a lot of empty hotels. That’s not so with urban markets, which hold a broader spectrum of demand generators. That diversity is keeping developer eyes on these urban markets.
“Urban has a little bit for everyone – corporate, transient, leisure, convention business, group business and local business,” says Mary Beth Cutshall, senior vice president of acquisitions and business development for Hospitality Ventures Management Group (HVMG). About 35 percent of HVMG’s portfolio can be defined as urban.
“The demand is robust,” she adds. “You don’t have to rely on one primary account or demand generator to drive business.”
Building up, sizing down
However, limited land sources in urban markets can have an effect on a hotel’s footprint, sources say.
“In the top five major metro markets, you’re looking at more vertical buildings,” Nichols says. “You’re looking at slightly smaller room sizes, too.”
However, when it comes to room size, he says that brands have done a good job maintaining integrity of standards. A brand might recognize the need for smaller rooms due to space limitations, but Nichols says that doesn’t necessarily mean rooms will see significant size reductions. He says that he also is seeing brands develop room footprints that can be economical for urban locations but also can translate to suburban areas without altering rooms.
Cutshall says that because sites can be tight and more expensive for urban projects, developers should look at options that would be the best fit for the market’s location and demand drivers.
“Some brands have the ability to have guestrooms smaller with smaller square footage, and you have to make sure that what you’re building and how you’re positioning it for the demand is a match,” she says.
As such, she says developers might have to consider reducing square footage not only on guestrooms but also for public space. She cites HVMG’s Indigo properties in Atlanta and Denver, which have less than 1,000 square feet of meeting space each. For the Atlanta property, the decision was made due to space confines of the existing structure. The reduction in meeting space for Denver was due to the square footage limitations and consideration for and highest and best use of space based on the market’s demand.
“You do have to take a look at all of the factors and what is going to be the best programming for the hotel, and what will it cost per square foot to allocate your programming to certain areas and what does it support for revenue,” she says.
At what cost?
Although space limitations certainly affect an urban hotel’s footprint, sources say cost also is a major factor.
Last year, construction costs across the United States increased about 4.5 percent, according to a recent report from HVS, “U.S. Hotel Development Cost Survey 2015/16.” Many markets saw a double-digit increase in construction costs, with New York City and California seeing the highest costs per room. Urban central-business-district markets such as Chicago, Atlanta and Dallas saw high construction costs as well.
“Construction costs in general are up, and it seems to be continuing to be increasing,” Cutshall says.
Those costs can hit developers’ wallets in urban locations due to the constrained site spaces, she says. Because the properties tend to be built vertically, more costly materials are used to accommodate the extra floors.
“It’s not wood framing where you might see that in a tertiary market or interstate location where it’s four stories,” Cutshall says. “You’re going beyond that; you’re going higher than that, and you have to incur extra costs.”
She says the sites can be more complicated due to their size. For instance, there might be a need for digging out an additional parking structure, which will add cost. Storage issues are another big factor when it comes to a limited space that might often trap construction sites to one block. Debris from construction, then, is not easily stored onsite. Storage for furniture, fixtures and equipment also needs to happen offsite.
“You don’t have the parking lot of a secondary market hotel to put a dumpster, and all of a sudden you have to accommodate for extra services and needs for that type of situation, which do add cost,” Cutshall says.
However, sources say the tradeoff is clear: While the cost to develop is greater, so too is the return on investment when it comes to ADR. For example, Ford says Miami and Fort Lauderdale can see a rate difference of between $25 and $30. And although he says the cost to develop would be higher in Miami, the ROI would also be greater.
New-build hotels are not the only projects to face high costs, however. Developers also need to keep costs top of mind when it comes to conversion projects, Cutshall adds. Existing buildings sometimes are older structures, and developers might run into problems with asbestos, safety issues, mechanical replacements such as elevators, new roofs and installing systems to meet ADA requirements, among others.
Depending on where the industry is in any given cycle, Cutshall says urban development will always be relevant.
“One of the reasons that developers like urban markets is that there are natural barriers to entry from a physical structure perspective, limitation on land, sometimes zoning, the time frame it takes, and cost of finding a viable site or location,” she says. “Those high barriers to entry always makes it desirable because in some ways there is more protection against a surge in supply for a market. It mitigates risk.”
Because of those reasons, she sees urban locations as always lending themselves to future development. However, she says the challenge will come when sites and potential buildings become so expensive that it gets difficult to pencil a deal.
“But that’s just a demand and supply issue,” she adds.
It might be difficult to argue that high barriers to entry are keeping developers out of markets such as New York City, where the city is on track to add more than 30,000 rooms if all hotels in the pipeline open. The market is No. 1 out of the top 25 markets for number of rooms in the pipeline, followed by Houston’s 17,864 rooms on tap, according to STR data.
“It does make one heed caution,” Cutshall says. “One of the things my team does quite extensively, more so now just because we’re in the chapter where the supply pipeline is so full, is confirming those projects that are coming through the pipeline and will be coming online.”
She says it’s important when developers are looking at an opportunity to determine the impact on existing rooms of new supply coming in the market; ask whether demand can keep up with the new supply; determine what potential new demand generators are coming or which current ones are shrinking; know what the economy is like; and establish what sectors hold strength and which ones are vulnerable.
“You definitely don’t want to be that last hotel opening up with a site that was more on the expensive side, so your overall cost basis is high,” Cutshall says.
Even so, Nichols is optimistic when he looks at historical data.
“There have certainly been some headwinds that have blown a little bit, but I’d call it more of a breeze,” he says.
He says the industry tends to get nervous when a cycle seems to be lasting too long, but looking back to look ahead helps to tell a story. For example, going back to the cycles of the early 90s for the hotel industry, as a percentage of year-over-year revenue-per-available-room growth, the average cycle lasts about 56 months.
“We’re in month 80 right now. You might ask: How can you say we have positive market traction? I would point out to you that the cycle that began in 1991 didn’t end until 9/11 happened, so that was 111 months of consistent growth in RevPAR, with one tiny little blip in there in 1998,” he says. “We have about 30 months – two and a half more years potentially – before we even get to the end point, and that end point was artificially ended because 9/11 happens.”
While he admits there might be cause for concern, Nichols cautions not to turn that apprehension into self-fulfilling prophecy without any hard data to back it up.
“All the numbers that I’m looking at that should indicate where the market’s going are not bad; they’re actually quite good,” he says. “If I’m the investor, I’m looking at that and saying, ‘OK, take the emotion out of it, just the numbers look pretty positive.’” ■
A focus on select service
Urban centers are seeing a big push of upper-midscale and upscale select-service hotels during this cycle, sources say.
“The days of the big boxes with lots of meeting spaces seems to be over as we’re seeing fewer and fewer of them,” says Mary Beth Cutshall, senior vice president of acquisitions and business development for Hospitality Ventures Management Group.
She says select service is desired due to the segment’s greater opportunity to offer a lot of different options for guests.
“The great benefit of select service is that they are extremely efficient to operate,” says Bruce Ford, senior vice president and director of global business development at Lodging Econometrics. “And when you can put them in a high rate area in an urban center, they can be very profitable to ownership groups. That’s the big drive.”