Friday, March 15, 2024

Six pitfalls for full-service hotel development (1/4)

Dan Voellm, MRICS

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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