Originally seen HERE.
The current hotel development market has been faced with escalating construction costs for several years, including but not limited to high interest rates, difficulty finding financing, long material lead times and labor shortages.
Historically speaking, construction costs have increased at a pace of about 5 percent per year, which has always been above inflation, as inflation has typically been around 3 percent, said Luigi Major, managing director of HVS Americas. “In the post-Covid years, that increased 8 percent in 2022 and 6 percent in 2023, providing a significant headwind for developers. The good news is that inflation has been coming down.”
Challenges still remain and a lot of projects are difficult to pencil in, Major continued. Labor shortages in the construction industry and supply chain disruptions have improved in recent years, but still persist. States like California have high-regulatory markets that have made construction difficult, as well. “All of that just adds cost, since the developer now has to hold the asset for five to 10 years until they can get approval to get it done and, all the while, they’re paying those soft costs,” he said.
The challenge of new hotel projects is the rising construction costs in relation to the achievable return for the hotel, said Christian Buer, managing director of Horwath HTL Germany. “The investment costs for a new hotel are around 35 percent to 67 percent higher than five years ago. The return on investment for new projects rose by only 20 percent to 25 percent in the same period. At the same time, bank interest rates have risen from the low-interest phase to a stable level of around 3.5 percent to 4.5 percent. In addition, the equity ratio has risen from 25 percent to 30 percent to 30 percent to 38 percent. This means that the development of new hotels is not economically viable, or only to a limited extent.”
Some states are more business-friendly, which makes development easier, Major noted. Florida, Texas and parts of the Midwest tend to be a bit easier. HVS has seen more popularity in the limited-service and select-service spaces.
According to CoStar’s latest June data, the volume of U.S. hotel rooms under construction reached its highest level in 16 months. Currently in the U.S., there are 157,713 rooms in construction, 266,619 rooms in the final planning stage and 333,827 rooms in the planning stage.
There’s a lot of pressure on development as a whole, said Mark Knott, vice president at real estate consulting firm Project Management Advisors. “The cost of debt to develop any project type is increased,” he said. “Post-pandemic, [it] has leveled off, but it hasn’t come down. Combined with inflated construction costs and now inflated debt costs, what used to be very safe development deals are now put on the margins. That creates smaller returns for investors and in turn, get harder to push forward.”
Fundamentals for Success
Knott said he is seeing a few things when developing and building. “Obviously location is key—hospitality is not just about the real estate developments but also about the revenue returns. Finding markets where the occupancy and ADR are confident and rising is key,” he said. “So, as in every real estate deal, location, location, location is important.”
Major agrees that location, but more specifically, the land is crucial for building success. “The number one cost that developers incur right off the bat is the land cost, with land being generally around 10 percent of the overall development budget,” he said. “I think the number one strategy is to make sure that the land is actually around 10 percent or less. There are many developers who do end up buying more expensive land, and then they’re trying to fit a round peg into a square hole, and it’s just difficult to make the deal work in the later stages.”
Major also sees that a lot of successful projects that get built are keeping it very simple. “Unfortunately it tends to be boring architecture, but it’s very simple architecture,” he continued. “It is a prototype that has generally already been developed by the brand so they can copy and paste it into their site plan, as opposed to having to reinvent the wheel.”
Concord Hospitality, with its long-time partner Whitman Peterson, broke ground on the first Marriott StudioRes brand hotel in Florida earlier this year. The project is expected to open in spring 2025. Concord expects to develop around 50 StudioRes properties. The company also has other properties in development, which is a positive change compared to the early post-pandemic years, said Carl Hren, Concord Hospitality’s executive vice president of development.
“Because of finance, financing rates and interest rates being so high, contractors and subcontractors have seen a decrease in their pipeline, and this has helped us,” he said. “While I wouldn’t say that prices have dropped, things have gotten a lot better; we no longer have contractors saying, ‘we can only hold this price for seven days.’”
“We’re seeing a lot more interest in our projects,” he continued. “We’ve got a project that will be going out on the street where we’re able to get five general contractors interested. The more competition you have and the more hungry that both the general contractors and subcontractors are, the better pricing you get.”
Driftwood Capital’s Jay Cooper, managing director, development and construction, said another challenge is the long lead times with materials, particularly transformers and electric equipment. “That’s across the board, with materials and fluctuating prices,” he said. “Particularly on long projects, which are in excess of 30 months of construction duration, you really have to try and mitigate the risk on material costs increasing.”
Cooper said hotels still sit in a bracket with commercial real estate so while hospitality is strong and has seen recovery, banks are very nervous, particularly with the office sector. Banks are being very particular in choosing their projects, especially in construction or hospitality, but he is seeing some easing.
Cooper suggests that educating investors and ownership on realistic and current costs may help projects get done. “There’s a happy medium of not just the fluctuating highs and lows, but what’s really a good price to be at,” he said.
Knott said he’s seeing of positive traction from mixed-use projects. On the higher end are condo and hotel or hotel and multifamily projects; a lot of the mid-range projects are dual-branded hotels, so there is a larger footprint and a better price point with some efficiencies in common areas.
Cost-Effectiveness is Crucial
Securing the right designer and making sure the building is the most cost-effective, low-cost structure for the location, and then diving into the plans and specs is crucial, Hren said. “There’s no real secret sauce—it’s making sure that everything that the designers are putting into the plans and specs is cost-effective.”
Contractors should have multiple options, giving them multiple vendors to compete for the business. “When you’re choosing the most expensive building materials and you’re making your specifications close to only one vendor, it’s going to be cost-prohibitive. We look to make sure that everything can be created in as competitive an environment as possible.”
Knott agreed, suggesting developers and builders work with general contractor partners to evaluate everything. “Drawings are kind of the best practice, but it may not be the most cost-effective way to go about it,” he said. “Bringing in our construction partners early, there are ways to maybe attack it in a different manner that still provides the functionality but at a better price point.”
New hotels must be developed and built with the future in mind, Buer said. “This means that the hotel must enable the operator to lower operating costs so it can achieve a higher return or rent,” he said. “The saying ‘the profit is in the construction’ is more important than ever. Building with the future in mind means thinking the hotel through at the planning stage. The specifications of international hotel chains, particularly in the areas of energy and construction, must also be critically examined. Are there cheaper alternatives without putting the guest at a disadvantage? Then developments become forward-looking and the hotel becomes more attractive in terms of fungibility.”
Bill Wilhelm, president and COO of R.D. Olson Construction, believes the industry will see some softening of construction costs for the balance of this year and into Q2 2025, but he is concerned that costs once again will rebound and increase as multiple projects currently on hold due to financing restrictions will all start within a short period of time once the financial market improves. “Pick the most experienced contractor early and start the process before end of 2024 to get in front of what’s to come.”
