Part 2: Two more pitfalls for full-service hotel development

(Part 1 here: www.ap-ha.com/post/six-pitfalls-full-service-hotels-1-4)

Part 1: Two pitfalls for full-service hotel development

Hotel development is a complex undertaking. It requires little of the skills to operate and monetize the asset. Owners and architects are often ill-equipped to measure up the requirements for running a successful hotel a few years down the road. While certain industry trends exist, fundamentals still need to be observed. Words of caution for those attached to specific brands or roles a hotel is meant to fulfill – in today’s world of hyper-efficiencies it is becoming more difficult to provide everything for everyone. Or specifically: provide a comprehensive range of service to all types of travelers. The real estate required to accommodate these service encounters has simply become too expensive to build. Thus, the question: is the classic full-service hotel concept in peril? The following article discusses the major challenges that negatively impact the financial returns for new-built, full-service hotel in many markets in Asia Pacific and presumably, the world. In this first part of the article,we discuss the cost of land and impact of seasonality. The second and third part of the article discuss the other four pitfalls. The fourth part of the article will outline strategies and band aids to address the six pitfalls.

1. Land cost:

Eye-watering to some, land values in Asia are rarely cheap. If they are, some flags should be raised. As many real estate markets remain opaque and exhibit varying degrees of inefficiencies, investors continue to see much of the value in the underlying land. Following decades of growth, many see continuous i.e. annual appreciation as a given. Sellers rarely leave money on the table for a buyer/developer to realize attractive returns. Bar any major corrections, the only answer is long-term hold. As a result, conglomerates and families have amassed significant land banks they can develop over time. After all, real estate ownership is not taxed in a major way. As a result, land is not realized efficiently while being commodified at the same time. Typical valuation reports assign the majority of the (income) value to the underlying land rather than the real property or building on top of it. Another layer to this conundrum is ground leases, common in various jurisdictions across the region. Income generating assets with a finite life will suffer from diminishing terminal values. As a result, investors require even more sophisticated underwriting. Meanwhile, significant down payments versus annuities further work against favorable returns under the time value of money principle. While the investment rationale the principle purports remains elusive in most markets, investors often favor lump sum upfront payments as a means to de-risk their development. As a market standard, such structures favor larger players with a strong balance sheet. While the (North American) rule of thumb for hotel development used to be that 20% of the development cost should be the cost of the land, there are markets in Asia Pacific where this share increases up to 90%. This creates a self-fulfilling prophecy for how real estate markets evolve – or end in bubbles’ burst. We don’t argue that prime pieces of land have no value. However, the nuances of location, permitted uses(and the requirements to change the use) and how they contribute to value appears to be less scrutinized.

2. Seasonality:

While market analysts and operators may lament or praise high occupancy levels, these are often convoluted by supply swings – to be discussed below. More fundamental to a hotel market is the underlying seasonality of demand. This is easier understood from traditional resort markets such as Phuket, Bali, and Maldives. While the former two managed to exceed the 70% in several years, Maldives lingers in the mid-60 percent range. While blessed by sun, beaches, geography, and infrastructure inclement weather is a major deterrent as are schedules of various (school and public) holidays. While weather patterns have become more erratic, they are unlikely to upset peak seasons in the medium term and holidays are here to stay. The only major factor would be for China to abandon its national holiday pattern of Chinese New Year and Golden Week and let workers schedule their holidays independently. Though it may stimulate consumption in a positive way, it appears we are far away from that happening. In a traditional city market with strong (corporate) weekday demand but limited weekend leisure travel, occupancy levels tend to peak in the low 70s. Suburban and getaway destinations usually see high weekend occupancy rates,but midweeks are a bust. Some properties have managed to capture MICE demand to drive midweek occupancy. However, just building the right facilities may not suffice to attract events. Having the right room product, amenities, positioning,and brand also play a role. In some cases, there may be a lack of awareness entirely or transportation limits the restrictions limit what organizers can deliver. Some destination marketing agencies, such as the Singapore Tourism Board (STB) or the City of Sapporo, work hard to establish and attract a series of events to reduce seasonality in the market. Notably, some demand generators are less prone to seasonality than others. Diversification in demand generators should be on anyone’s agenda when looking to reduce seasonality. Thus, a traditional hotel/resort investor can rarely defy seasonality trends single-handedly to drive returns- unless they opt for differentiated business models.

In the second part we will discuss the role of markets and labor. The third part of the article discuss the remaining two pitfalls. The fourth part of the article will outline strategies and some band aids to address the six pitfalls.

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Hotel development is a complex undertaking. It requires little of the skills to operate and monetize the asset. Owners and architects are often ill-equipped to measure up the requirements for running a successful hotel a few years down the road. While certain industry trends exist, fundamentals still need to be observed. Words of caution for those attached to specific brands or roles a hotel is meant to fulfill – in today’s world of hyper-efficiencies it is becoming more difficult to provide everything for everyone. Or specifically:provide a comprehensive range of service to all types of travelers. The real estate required to accommodate these service encounters has simply become too expensive to build. Thus, the question: is the classic full-service hotel concept in peril? The following article discusses the major challenges that negatively impact the financial returns for new-built, full-service hotel in many markets in Asia Pacific and presumably, the world. In this second part of the article, we discuss the role of markets and labor. The third part of the article discusses the remaining two pitfalls. The fourth part of the article will outline strategies and band aids to address the six pitfalls.

 3. Market pricing vs supply cycles/barriers to entry:

In the first part, we briefly touched on the strong occupancy performance of Bali, Phuket, and the Maldives. The story occupancy does not tell is price: these three destination shave successfully adjusted off-season pricing to cater to less discerning travelers and source markets helping to drive occupancy levels. While the inventory may be subject to greater wear and tear, owners seem amenable to this trade-off. However, these tactics are only one trick of the 3^rdhorseman. In many cases, price, or more specifically average rate, is seen as a result of supply cycles. Without a doubt, increases in supply when demand (and all other factors) is constant will often lead to lower or stagnant average rates. Conversely, faced with growing demand and stable supply, average rates tend to grow more rapidly. That’s simple supply and demand economics. Investing in a market – particularly for existing assets - it is beneficial to understand the barriers to entry for new development, as new supply may impact top line performance projections. From a macro perspective, these barriers tend to change either very slowly (driven by local government regulation) or suddenly during major market events. While changes to building regulation tend to be publicized, investors are usually at the mercy of both being outside their control. More fundamental than supply cycles and barriers to entry is the fundamental market pricing. Nowadays, this may be the friendliest of the horsemen. As markets are inefficient, innovative development schemes, at times supported by infrastructure enhancements, may provide opportunities to elevate a development’s positioning supported by induced demand. Introducing a superior product into a market is certainly a risky undertaking and comes with higher investment costs. Unfortunately, developers are not trained to read these opportunities well and frequently projects fail to materialize at great cost to the sponsor. One common example is when the project vision calls for a 6- or 7-star hotel. Celebrated with superior levels of dignity and exaltation,projects lead often fail to embrace what ultra-luxury developments require.Many have gone the path of ‘build it and they will come’ – reportedly almost just as many are still waiting. At the end of the day, affluent travelers a)number relatively few, b) require convenient access c) are drawn to unique locations d) and places other affluent travelers go, e) seek exclusivity, and f) may not travel year-round as they lead busy lives. The Maldives grew to fame catering to the luxury segment and only later diversified and banished the slow season by applying favorable pricing tactics (and less discerning travelers). Key here is that the investment into infrastructure and awareness created started from the luxury traveler. Understanding their motivators is key to capturing their spending dollars. And no, the argument ‘I stayed at so many luxury hotels and know what I’m talking about’ is not a sure shot to getting a luxury hotel or resort development right. Long story short, we caution to overestimate how viable it is to attract enough high-end travelers to a new or growing destination more or less year-round. A similar rationale should be applied to the ability to attract inbound demand, but that’s less relevant here.

4. Labor cost:

The pandemic was a shock to labor markets. Across Asia, the lockdown of borders saw many migrant workers return to their home country. As a result, qualified front line and less qualified support staff exited many industries, including services (not only hotels, but restaurants, airlines, airports, and cruise) plus construction. Turns out that in most developing and mature markets, homegrown talent is less inclined to pursue careers in these fields. While the hospitality industry managed to overcome itself and embrace new modes of operation to become more efficient, labor remains scarce and more expensive than before. All things equal, the bottom line of hotels has not improved. In fact, after inflation on consumables and electricity, hotels are off worse. We need to add that there are many markets around the world that have been able to pass on the higher costs onto the consumer/guest, in some cases even improving their bottom line. However, there are shortages of qualified and trained labor. What that means is that any hotel in pre-opening needs to embrace talent as an integral part of the value chain to deliver quality service. To this day, this is by far not the case in many existing hotels. Furthermore, hotels opening in less established areas will find that their staff does not find the right type of amenities in the community that support their lifestyle. Additional facilities may need to be introduced to make life more attractive outside working hours. The Maldives is a great example where back of the house areas at luxury resorts are at times better than the front of house in 3-star resorts. Creating a community with sport competitions and social programming is not something the industry subscribes to freehandedly. Technology has been a great help to increase efficiencies and streamline manning plans. However, in many cases this comes with reduced personalized service (at times desired by a guest, but not all). From a planning point of view, developers may thus rethink their F&B programming and will soon run into operators and their brand standards. By now, many operators have come to realize that they need to be more open-minded about F&B. Similarly, while MICE can help to lessen seasonality, it has significant labor requirements, many of them hired on a temporary basis. That can be challenging in destinations with a limited labor pool. Striking the balance between these considerations is critical. Operations will always do the best they can with the hand they are dealt with. Making sure they have the best possible hand is part of the developer’s task when seeking better returns.

In the third part we will discuss the role of construction costs and (brand)standards. The fourth part of the article will outline strategies and some band aids to address the six pitfalls.

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