California remains popular, challenging for development
 
California remains popular, challenging for development
31 JULY 2017 8:31 AM

Demand for hotels in California continues to drive development, but there are concerns that supply issues could at some point overcome the state’s protective high barriers to entry.

REPORT FROM THE U.S.—Hotel development in California continues on at an increasing rate. Atlas Hospitality Group’s California Hotel Development Survey for mid-year 2017 shows the number of hotel openings jumped 53% year over year.

So far this year, the California market has seen 15% more new hotels and 6% more rooms under construction compared to mid-year 2016. In the planning phase, the market reported 773 hotels (a 37% increase over 2016) with 113,973 rooms (a 35% increase).

The average size of hotels opening is 130 to 140 rooms, said Alan Reay, president of Atlas, and a vast majority of them are branded under Marriott International, Hilton or Hyatt Hotels Corporation. They typically cost more than $100,000 a key, he said.

San Francisco is an area with huge barriers to entry, he said, but the city recently changed zoning in a large section of the city that will allow light industrial, commercial and hospitality construction.

“We might see in San Francisco what we have seen in downtown Los Angeles over the last 24 months,” Reay said.

Downtown LA is one of a few areas that can handle higher density, he said, and the city has been supportive of new hotel development with tax breaks.

It’s generally difficult to find available land in locations anywhere near a beach, he said.

General conditions
California remains a hot state for hotel development, said Corry Oakes, CEO of OTO Development, which has the Homewood Suites San Jose North, the AC Hotel San Francisco Airport/Oyster Point Waterfront and the SpringHill Suites Belmont/Redwood Shores under development and recently opened the Hampton Inn & Suites Santa Monica and the Courtyard by Marriott Santa Monica.

The state overall has had a prolonged period of above-normal market performance, Oakes said. But, on a micro level, the hotel industry is still a street-corner business that can vary depending on the specific location, he added.

California’s hotels seem to be more susceptible to violent performance swings than hotels in other states, he said. During the 2001 recession, the decline in revenue per available room in California was multiple times what it was for the rest of the country. Similarly, in 2008 and 2009, California was “substantially worse” than other states, he said.

On the other side, it’s had a greater trajectory on performance improvement, he said.

“If you can handle the violent swings, it’s great business,” Oakes said. “If you happen to time the swings wrong or your balance sheet can’t handle the stress of missing performance projections pretty significantly, it can be a tough situation.”

Desirability
Developers believe if they can find the right piece of land in the right location in California, someone will try to build there, said Mike Bellisario, VP and equity research senior analyst at Robert W. Baird & Company.

“Regardless of the supply structure, developers are always going to find a way to develop. There’s always someone who’s going to give them some money,” he said.

Barring a downturn in the fundamentals, which hasn’t happened yet, development will continue in California, he said noting markets in the state are performing better because of the limited supply coming in, which is due to the structure of the state, zoning laws, taxes and bureaucracy.

The demand is still strong among consumers, which is a big part of the reason developers and owners still want to build hotels in California, Bellisario said. His long-term view is that conditions will remain favorable, because everyone wants to be in California.

Still, some recognize it’s hard to build there and don’t want to commit to the extra time and effort it takes to complete a project, which helps buffer against supply, he said.

Construction challenges
Revenue-per-available-room growth is flattening out, Atlas Hospitality’s Reay said, and the cost of construction in the state continues to rise quickly. The development of retail and residential real estate adds on to the cost of labor and materials, he said. Construction costs are 25% to 30% higher than they were 12 months ago, he said.

“Everyone is on full employment on the construction side,” he said. “People are putting bids out. (Construction) companies are saying, ‘I don’t want the business, but if you’re willing to pay me this, I’ll take it.’”

OTO Development sees construction prices jump dramatically in California, unlike other markets across the country, Oakes said. Those who aren’t in the market every day might not fully appreciate this, he said, adding that the underwriting cost estimates that are more than six months old are already out of date in some parts of the state.

“Obviously it’s a wonderful market for real estate development from a long-term perspective,” he said. “Right now, all contractors are very busy.”

What about supply?
OTO’s real-estate team spends a lot of time trying to understand supply in the market, Oakes said. California has had a long period of lower supply compared to the rest of the country, and people looking in their rearview mirrors see strong performance in the state, which makes them to want to develop there.

Barriers to entry create lengthy development processes, Oakes said, and less-experienced developers will misjudge that timeframe. In his company’s experience, a project typically takes three to six years to complete, but that’s after finding a piece of land and putting it under contract. Following that, there’s a lengthy entitlement process.

In the Los Angeles market, specifically, there has been limited supply growth of about 1% for the past five years, said Todd Turner, VP of real estate at OTO Development. The forecast, however, shows 3% growth over the next five years. Correspondingly, RevPAR growth has been almost 10% for years, he said, but CBRE predicts less than 3% growth over the next five years.

“That’s a big change attributed to supply,” Turner said.

California overall can absorb the new supply of hotel rooms that have recently opened and are currently under construction, Reay said, and it won’t have a negative effect on revenue and profitability. He is concerned about projects in the early planning stages, however, since they won’t be coming online until 2020 and later. It depends on the economy and how it continues to grow, he said.

“I think in the short term we’re OK, but long term, I would definitely be more cautious,” he said.

Retiring inventory
Older properties won’t fare as well as newer hotels coming online, Reay said. The hotels with owners who haven’t kept up and invested back into their properties will suffer, he said.

“Business will gravitate toward a newer product,” he said. “We may very well see a number of hotels exiting the market, either torn down or reconfigured for something else.”

California is trying to find housing for lower-income families and the homeless, he said, and a number of cities are looking at older hotels as possible solutions.

Overall the state will see a positive growth pattern, Reay said, but there might be some balancing as some inventory is removed from the market. The pace of hotels leaving the market is not nearly as fast as that of newer product coming up, he said. There might have been 10 to 15 hotels shut down for code violations or demolished within the last 12 months, he said.

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