HOTELS

Laurence Geller

It's All About Supply
May 19, 2008

It has been a year since the first glimmerings of economic problems surfaced to the public at large. Some ignored the issue while others thought any problems would be local and limited to a small section of the housing market.

The international community assumed that this was now a global economy with the new engines of economic growth making everyone else independent of the vicissitudes of the U.S. Thus, it was glibly presumed, other nations would be immune.

It wasn’t until late in 2007 that even those with an ostrich-like mentality realized this wasn’t a problem limited to a few homeowners who had over-borrowed on mortgages aggressively offered to them by slick, commission-driven salesmen whose only motive was quantity and not quality. After all, the financial markets’ insatiable appetite for sliced, diced and packaged debt had to be assuaged like a hungry beast so earnings could be immediately reported and the baying mouths of hungry bankers fed.

The momentum of gloom rapidly increased as a new year dawned and, the closer to Wall Street, the more the recessionary depression strengthened. Bank write downs spawned more write downs and the term liquidity crisis became commonplace. Credit availability evaporated with the speed of water in a desert as one financial institution after another searched for balance sheet-boosting infusions. Our nation’s economy inevitably slowed down.

The talk was all about how low the economy would go and for how long. The Fed stepped in time and again, headlines blared bad news on top of bad news, economic prognosticators had endless field days, the stock market became a roller coaster and Bear Stearns disappeared from view with the rapidity of the Titanic’s abrupt demise.

China and India’s growing middle classes consumed commodities on an unprecedented scale. Energy prices soared to unimaginable heights alongside the price of gold. Food prices shot up. Rice became an unaffordable commodity to all too many who depend on it for their daily survival. Iron ore soared 90% in months. Steel prices increased by 50%.

As our interest rates dropped, so did the value of the dollar. Inflation fears became headlines. Unemployment started to creep up and the world realized that all of the economies were inevitably linked. If the U.S. caught cold, other nations shivered.

The term Sovereign Wealth Funds vaulted into our daily lexicon with the speed of summer lightning. The real estate industry slumped, foreclosures increased, house prices dropped, home building all but stopped, and finger nails were bitten to their quick while people tried to answer the always personally vexing questions “How bad? How long? What does it mean for me?”

I certainly don’t have any answers to those questions. However, I wanted to offer some thoughts which may give some incremental perspective as each of us in the lodging industry struggles to manage through this volatile and uncertain time.

Lodging demand is linked to GDP. It is as simple as that. Perhaps there is a lag between GDP and demand’s reaction, perhaps there is not. It is easy to figure it out on a sector by sector basis, so each of us can answer that question for ourselves. I personally learned a long time ago that I can’t change GDP and have long given up trying to forecast its growth rates, so my mantra has been, is, and will remain to plan for the worst and hope for the best.

If we can’t forecast GDP and thus demand, what can we forecast? The answer is logical and simple. Supply. It’s all about supply.

Every night, each pricing-denominated segment of our business has to accommodate demand for a finite number of rooms. The fewer number of total rooms available then the higher the occupancy will be. Therefore, if new rooms come into the market, the less the occupancy will be for everyone. It’s all about supply.

If you accept that simple truism then logically the economy segment, with all of its supply growth, will lead the way downward in terms of diminished demand growth and will feel the impact of supply and demand imbalances both the hardest and soonest. Mid-scale with food and beverage will be next and the last to follow the downward curve will be the luxury end of our industry.

The reverse will logically happen as GDP growth rates increase and demand growth inevitably increases again. Luxury will come out first and economy will be the last to recover.

While demand for room nights will certainly continue to grow well into the foreseeable future, it is supply that will dictate what occupancy will be and, as a logical consequence, what pricing power we have. It’s all about supply.

It is straightforward for each and every one of us to calculate the impact we will feel on our individual properties as the cycle turns and recovery inevitably and inexorably happens. It’s all about supply.

National statistics effect all of us but, even if you are part of a national brand, owner or operator, local issues truly impact each of our  pocket books. Each of us must look to our own markets to understand what supply is going to come on stream in the next few years. Once done, you will quickly understand what your future will be.

The recent years of diminished supply growth and the lack of future supply are the bright light of hope for our industry. Personally, that very light means that I see sunny days ahead. Why?

I mentioned steel prices have gone up dramatically in the past months. So have many other key construction ingredients. The entitlement process has gotten slower, more complex and more expensive. The length of time it takes to develop a property has increased by as much as 20% over the past few years. The dollar is weaker and, consequently, foreign bought goods more expensive. Prices for goods from China and India have increased, as has the production time. Energy costs have radically increased and made the cost of delivery and transportation of every component needed to build a property much more expensive than before.

With all the uncertainty about pricing, the amount of contingency in any developer’s budget has to increase significantly. The more complex the project, the longer it will take, the more the risk, the greater the financial contingency line items have to budgeted.

The net effect is that the price of building a new property has jumped up and continues to do so in a relatively unabated manner. Debt is scarce, and if available at all for a new build, is very expensive. More equity is needed and the returns will be slimmer as equity is a highly priced commodity.

Factored in to a would be developer’s equation has to be the current slow down in room rate growth, the increasing and uncertain rise in costs of energy and related products, property tax hikes nationally, worries about union activism, uncertainty over income tax and capital gains tax rates. Heads will be scratched conceiving how to make the returns needed for the increased percentage of equity or even to pay the increasingly expensive mezzanine debt.

The conclusion is obvious—there  will be less supply. The higher up the quality and product complexity scale, the harder it will be to bring in new supply.

It seems reasonably logical to assume that the quicker to build, cheaper lodging products will be the easiest to build and therefore supply will come back first in those markets and luxury will come back far slower. I would suggest that if a luxury product isn’t under construction now, then given an average three-year development process, it is unlikely to be open much before 2012. It’s all about supply.

If TV’s talking heads and constantly jabbering pundits are correct and GDP starts to recover during 2009, then it seems logical to suggest that we will have increasing demand and limited new supply. The result for our industry will be a quick recovery, compression pricing and higher levels of profitability.

Inevitably the values per room will increase on a market and segment specific basis and yesterday’s high sales prices will begin to look cheap as the new decade begins and the halcyon days of a new upward bound cycle will quickly make us forget the worries of  today. It’s all about supply.

As an industry we are smarter this time around. We were more productive going into this volatile environment, we are more disciplined about pricing (at least so far!) and are not going to discount rooms in the faint  and often forlorn hope of inducing demand. Today, Internet travel agents are merely a tool in our kit of revenue-generating options and not our competitor. We have hopefully learned that when one of us drops prices in the hope of stealing a competitor’s share, then others will follow quickly.

Sure, there will be problem properties and attention grabbing headlines will certainly follow. The inevitable gloom and doom prognosticators will have their few minutes of fame. However, the reality is that we are a healthier industry than ever before and with a lack of new supply clearly in our future we have a bright and dynamic future ahead of us. It’s all about supply.

By the way, I have probably over used the concept of logic in this discussion. So here is the caveat: You can’t rely on people being logical. After all, if everyone was logical, then men would be riding the bicycles without the cross bar!

Posted by Laurence Geller on May 19, 2008 | Comments (3)