U.S. Economy/Introduction to Hospitality Market
Most economic forecasters believe that the past several quarters of economic growth were partly a result of fiscal stimulus. Based on that, the forecast for 2011 is for slower growth as the supports and stimuli are now dissipating. The recovery now depends more heavily on the private sector, which faces weakness in income based on high unemployment, reluctance of businesses to rehire aggressively and large overhangs of vacant homes and unused industrial capacity. Moreover, availability of credit is expected to be slow. Goldman Sachs is forecasting a reacceleration in growth to 3 percent in the fourth quarter of 2011 as the headwinds gradually dissipate.
This jobless recovery is creating an environment where expectations from several economists are for 10 percent unemployment again in 2011. Inflation is expected to remain well under control going forward based on the latest survey of Federal Reserve Board likely actions. The following chart shows the Goldman Sachs Forecast for key indicators of the U.S. economy though we have already mentioned that many believe unemployment will actually climb next year:
2009 2010F 2011F
Real GDP -2.6% +2.7% +1.9%
CPI -0.3% +1.6% +1.1%
Industrial Production -11.1% +5.7% +2.4%
Unemployment Rate 9.0% 9.7% 10.0%
Source: Goldman Sachs
Will the recovery be strong enough to continue to boost lodging demand and pricing (ADR)? We’ve framed our response to this question considering the factors that will impact travel demand in 2011. A review of business travel shows us that as companies anticipate lower demand, certain facets of business travel ceased (sales training, multiple person sales calls). In a recovery, companies anticipate a higher level of activity and business travel volume started to increase earlier this year, leading to recovery of transient occupancy levels in hotels.
According to PricewaterhouseCoopers (PwC), the three main factors affecting leisure travel are wealth, cash flow and jobs. As we assess each of these, we see a foundation for consumer spending growth. Figure 1, at the end of this report provides a graphic depiction of the factors affecting lodging demand.
■ Wealth effects are important, and housing has been the key driver. From a peak in 2006 of 56 percent above the long-term trend, home prices have fallen 30 percent, to a level five percent below the trend. The consensus is that we’ve reached the bottom in national home. In terms of consumer spending, the key is stabilization. As consumers see stability in their own net worth, and memories of steep declines recede, households are expected to look ahead to lifetime earnings and have greater confidence to increase spending on travel.
■ Consumer cash flow is resuming. Through a combination of debt pay down, reduced availability of credit, and falling tax payments, consumers have cut debt service obligations from 19 percent of disposable income in the third quarter of 2007 to 17 percent in the first quarter of 2010, which is closer to the long-term average.
■ Job growth remains key. The unemployment rate will remain high, but job growth has resumed, and household expectations on job prospects will gradually recover as the unemployment rate moves in the right direction.
The overall U.S. economy has a significant impact on demand for hotel rooms. Employment and housing are still weak. With tax policy possibly impacted by this week’s elections, and a jobs bill being discussed because unemployment is still approaching double digits, at least we are past the trough in this time of economic uncertainty. The excesses of the past three decades caused this recession that we just endured for almost two years.
A look at the key indicators of the economy shows that we are clearly in a recovery mode, albeit a recovery that is not yet robust and is in fact growing at a two percent per year rate.
Today’s economy has had an enormous impact on the fortunes of the U.S. lodging industry. Fortunately, all indications are that the U.S. economy is improving. Some markets have been impacted more than others. According to Smith Travel Research, (STR) the U.S. hotel industry is projected to end 2010 with increases in two of the three key performance measurements, according to their most recent forecast.
We estimate that U.S. revenue per available room (RevPAR) growth during Q3 2010 was approximately 8 percent vs. 6 percent growth in Q2 2010. RevPAR growth strengthened throughout most of the quarter but stabilized around the high-single-digit and lower-double-digit areas. We view this leveling off of growth as the next step in the cycle as occupancy growth begins to slow and is replaced by rate growth. STR projects 2010 occupancy will increase 4.4 percent to 57.1 percent. Average daily rate (ADR) is expected to end the year virtually flat with a 0.1 percent decrease to US$97.74, and REVPAR will rise 4.3 percent.
STR expects that supply will grow 2.2 percent during 2010, and demand will increase 6.6 percent. They further project the industry will end 2011 with increases in all three key metrics. Occupancy is forecast to rise 1.4 percent to 57.9 percent; ADR is expected to be up 3.9 percent to US$101.55, and REVPAR is projected to rise 5.3 percent.
U.S. Lodging Market
Favorable supply and demand dynamics are clearly setting the stage for a strong industry recovery. Q2 2010 was a turning point for the U.S. Lodging Industry with REVPAR and average rate turning positive for the first time since Q2 2008. The combination of limited supply growth and cost savings that have been put in place during this past recession bodes well for net income going forward for many years to come. There is indeed a benefit to a slow recovery which is being forecasted by many pundits. Supply growth will continue to be moderate, lenders will likely continue tight lending practices and as a result, the up cycle should last longer.
The Consulting and Valuation division of HVS International has issued revised forecasts for the U.S. lodging industry. The outlook for 2010 is for greater strength than previously anticipated, although average rate is forecasted to fall below the level recorded in 2009. The industry is now expected to recover more quickly than previously anticipated, and to regain stabilized levels of operation by 2014. Hotel values are also expected to rebound more rapidly, fueled by both stronger fundamentals and improving investment market conditions.
The following chart summarizes the forecast of occupancy, average rate, and RevPAR for the U.S. lodging industry through 2015:
Demand growth resumed in 2010, led by select markets that had recorded positive growth trends in the fourth quarter of 2009. The pace of demand growth has accelerated through the year, and HVS now forecasts that lodging demand in the U.S. will increase by 7.5% in calendar year 2010. A return of business travel and some group activity have contributed to these positive trends. However, we believe the resurgence in demand is being fueled in part by the significant price discounts that are now widely available. These discounting policies have resulted in further decreases in average rate through the first three quarters of 2010. The magnitude of the average rate decline is forecast to diminish over the balance of the year, as demand continues to strengthen.
The HVS forecast for 2011 anticipates that demand growth will decrease from the accelerated pace achieved in 2010, as the economic recovery is expected to continue at a moderate pace. As employment levels improve through 2012 and 2013, demand growth is forecast to increase, but will remain below the levels recorded in 2010. The commercial and meeting and group sectors are expected to continue to strengthen throughout this period. These trends, combined with the low levels of supply growth anticipated through 2012, should boost occupancy to above the 60 percent mark by 2012, according to HVS. Strengthening demand and occupancy should permit hotels to reduce and eventually eliminate the deep discounts implemented in 2009 and 2010. The current HVS forecast anticipates the U.S. lodging industry will stabilize by 2014, with occupancy of 62.7 percent and average rates of $117.54; this equates to roundly $98.00 in constant dollars, which is on par with the average rate level achieved in 2006. RevPAR in 2014 is forecast at $73.71, or roundly $62.00 in constant dollars.
The increased demand from the slowly growing economy is led by a combination of leisure travelers, gradually returning corporate profits, and finally the meetings sector. According to the U.S. Travel Association, business travel will be up 2.5 percent in 2010 with leisure travel up 1.9 percent. According to Rubicon, the group market is pacing strongly for 2011. Additionally, the latest travelhorizons survey indicates that travel intentions of U.S. travelers continues to improve, which is certainly good news for the lodging industry.
Moreover, the latest (October, 2010) YPartnership survey of travelers indicates that 27 percent of travelers make “last minute trips” and that those trips are planned, on average, 6 days in advance! This means to us that any uptick in the economy can be a quick reward for the lodging sector. One of the forces stimulating this last minute demand is the concept of “flash sales.” This appears to be a trend toward more “impulse” travel according to Peter Yesawich, author of the study.
California Lodging Market
There are only a few markets in California that are currently thriving. These include San Francisco/San Mateo, with an occupancy rate through Q3 of 76 percent and average rates of $124, Santa Barbara with an occupancy rate of 66 percent and average rate of $141 and Santa Monica/Marina del Ray with a booming 78 percent at $203!
The chart that follows this report shows each city in California with occupancy and rate for 2010 through Q3. Note that average rates are not up in any markets except for the above because until occupancy grows to a certain level (usually about 66 percent) there is minimum opportunity to drive rate. In some cases, even strong markets like Santa Ana, Newport Beach, Anaheim and San Diego were unable to grow rate and are just starting to turn the “rate” corner so to speak.
San Diego Lodging Market
In San Diego, the leading economic indicators were up for 15 consecutive months according to the Burnham-Moores Center for Real Estate at the University of San Diego. However, the past few months have been flat. Will average rate growth finally return so that profits in the lodging sector will improve? In San Diego’s hotel sector, the second quarter of 2010 began to move toward positive growth in revenue per available room (REVPAR) based on increases in demand (rooms consumed) of 7.7 percent and decreases in average rate of 6.1 percent for year to date 2010 through June.
REVPAR trends are be up for Q3 based on Smith Travel Research (STR) reports on San Diego. Hotel financial performance in San Diego will remain well below the peak of 2008 with a significant impact from both rate discounting caused in part by a reliance on the online travel agencies (OTAs) and a lack of group business.
While a return to early 2008 levels of business travel is not yet likely, a significant amount of deferred business travel is having an upward impact on room demand, according to a Tourism Economics report ordered by the San Diego Convention & Visitors Bureau (ConVis). Room demand has grown in each of the first 9 months of 2010. Group hotel bookings remain significantly weaker than transient room demand, but San Diego hotels have outperformed the state of California and the U.S. in terms of both demand and occupancy growth according to the report. For the first time in 2010, average room rates increased in San Diego albeit for a .4 percent increase in June.
Occupancy levels through September, 2010 are 69.1 percent at an average rate of $123.46, up from 65.2 percent occupancy year over year but down in ADR from $127.54. A return to 70 percent occupancy levels enjoyed by San Diego as recently as 2008 is not forecast to occur until 2013. At that time, there should be sufficient pressure to push rates up above the cost of inflation.
Most submarkets in San Diego have seen positive REVPAR growth this year, led by occupancy rates. No market has yet to fully recover in ADR. Occupancy in the Northeast submarket is up 12 percent year over year while La Jolla is up 9.7 percent and downtown is up 6.2 percent. Mission Valley moved up 4.7 percent, Carlsbad/Oceanside is up 3.8 percent (but negative REVPAR growth), San Diego South and East are up 3.6 percent and SeaWorld/Airport/Old Town is up just .6 percent, also with negative REVPAR growth. A full forecast appears at the end of this report.
The increased demand from the slowly growing economy is led by a combination of leisure travelers, corporate profits that are beginning to return and a desire to end a recession. Steve Swope, CEO of Rubicon says, “The average daily rate (ADR) shortfall is narrowing further.” In a slide presented to R. A. Rauch & Associates, Inc. for this conference, Rubicon shows group business improving markedly in San Diego.
The bigger question is whether average rate growth will return so that profits in the lodging sector will improve. Our analyst, Jeffrey Carlow, took a look at the public companies in both the lodging and cruise sector. He found the growth rates were much higher for the resort sector than the other hotel categories based on the severity of the hit they took in the recession and the consumer base that they attract.
According to Carlow, “they are seeing a substantial rebound in occupancy as well as rates. This is a huge improvement from the dire situation they were in during late 2008 and 2009. The 5 year growth rate as well as the low P/E multiple shows how cheap the stock is and how impressive the future of the companies are. The cruise lines are also set up for very strong growth at relatively cheap P/E multiples due to the low fixed costs they incur and the fact that their occupancy can only be headed up from here since it has been at historic lows for the past 2 years.” Mr. Carlow’s analyses are located at the end of this report.
Lodging stocks began to recover before revenues hit bottom. This is an indication that some of the trading was done in anticipation of the recovery. However, the strong fundamentals should provide room for additional upside. Given the extended period of limited supply growth, long term investment returns should be available throughout this upcycle.
Assuming the above scenario, what will be the impact on net income and hotel values? PKF Consulting reported that 9 of 10 hotels saw a drop in profits in 2009. Naturally, this was based on reduced occupancy and ADRs. In San Diego, HVS International reported a $48,000 per room drop in hotel values in San Diego. This is only bad news if one needs to sell or refinance. The good news is that values will begin to increase once REVPAR increases enough to compensate for increases in operational costs.
The improved outlook for the lodging industry fundamentals extends to hotel values, which are now forecast to rebound by 16.1% in 2010. This recovery is also being fueled by lower equity return requirements, driven by the large amount of equity capital entering the hospitality sector and the scarcity of quality assets for sale. Similarly, the mortgage component of the investment equation is returning to more normal levels. Debt is increasingly available for high-quality assets, as lenders have recognized that the lodging sector is recovering. Although spreads for hotel debt continue to be at the upper end of the range for commercial properties, the prevailing low cost of capital is keeping hotel interest rates at low levels. Loan-to-value ratios remain conservative, reflecting the lingering effects of the credit crisis. With lowered debt and equity return requirements, hotel values have begun to rise from their lowest point in 2009.
Improving fundamentals are expected to combine with a broadening of investment activity to drive values higher over the period 2011 to 2014. Accelerated average rate growth is expected to result in exponential increases in net income levels as compared to those recorded at the low point in the cycle, which in turn will support significant value increases.
Individual time horizons will be driven by knowledge of the market and operating skills as well as the current loan status of individual assets. Value creation is made by buying at the right time. Moreover, operating fundamentals are critical. In other words, manage your hotel first and foremost. An explosion of transactions is fast approaching due to the maturity of loans. Meanwhile, values are not quite predictable in the industry due to volatility of financial performance, risks of inflation, terrorism, and the rate of growth of economic fundamentals.
The advice that comes from all of this is simple. Do not sell if you are able to hang on for a few years when occupancy and ADR levels return to 2007 levels. This may take several years but it will happen sometime between 2013 and 2015. We are certainly happy to assist lenders, owners, asset managers and managers with any analysis they need to make on their San Diego hotels.
Sure, the recovery will be muted for many reasons. Corporate expense accounts are clearly loosening but there still remains a bit of the “AIG effect” that put a damper on group business in 2009 and early 2010. This pushes hoteliers to rely on leisure business, which is now being dominated by the Online Travel Agents (OTAs), and this may somewhat mute the otherwise positive effects of a corporate travel recovery in the near term. The U.S. budget deficit is real at $1.35T (yes “T” for trillion) and thankfully, a commercial real estate meltdown has not come to fruition in the lodging sector. Unemployment is still at unacceptable levels, but has certainly hit near the bottom.
There is certainly good news. The recession has ended, and we are truly seeing signs of a recovery. Interest rates remain low, and the federal government seldom moves rates in an election year. Moreover, vacations are still a high priority for U.S. residents, who will be spending more freely when the recovery proves to be real to them. All indicators point up. Airport arrivals are moving in the right direction; hotel demand is up; ADR is finally up and supply is leveling off. It is the right time to be an owner…the beginning of the recovery.
New supply in San Diego is expected to be less than 1 percent in 2010 and 2011. If demand grows by the average of the last 30 years, occupancy will move up in 2011 again. Following a two-year recession, there is unusually high “pent-up demand.”
If you are asking if we will see an increase in profits, the answer is finally yes! Costs have continued to increase, and average rates are just starting to catch up with our modest inflation. Hotel values will remain somewhat depressed this year but as indicated on the HVS chart, are headed back up. Debt markets remain elusive so hang on if you can – there is light at the end of the tunnel. The tunnel only appears to be dark and endless, which is not a pretty picture if your interest payments put knots in your stomach.
Robert A. Rauch