Hotel Hell - The Zombies Cometh

After reading some downbeat assessments of the U.S. hotel business in the media recently, I decided to circle back and get an update on the New York City hotel market. I caught up with John Fox, SVP at PKF Consulting and their New York City hotel guru.

John confirmed what I intuitively anticipated, that considering the travel slowdown I had reported on back in the fall in my piece New York City Hotels Going from Foist to Woist and Mike Stoler's Real Deal article on insane hotel prices I cited in a piece earlier this month.. According to Fox, PKF is expecting a 26% REVPAR (revenue per available room) drop in calendar 2009. Interestingly, about 16 percentage points of this is coming from rate declines and 12 points from the occupancy drop caused by the travel slowdown (#s don't add due to rounding).

As an aside, many in the industry have been talking about hoteliers getting smart regarding price cutting, having learned their lesson after 9/11. During that time period, internet hotel reservations were still ramping up significantly. I remember because I owned Hotels.com in my fund big time.....BOOOYA! The hotels put all their excess room availability online and saw a race to the bottom on price, as internet sites discounted the rooms like crazy to move them. The lesson was, you can boost occupancy by X%, but you put huge pressure on the rates you can charge for your entire hotel, 50 or 60% of which would have sold at higher prices. Long time readers of Urban Digs who understand how markets work, also know by now, never to believe that an industry has "learned its lesson." If there is excess supply, all it takes is a few guys holding weak hands to start cutting price and eventually the whole market will follow (we are seeing this in residential real estate in New York City now). Trust me, it's an immutable law of the universe (price fixing only works for periods of time when there is lots of industry concentration and no truly weak hands.....even OPEC can barely manage it).

It's not surprising then, that despite New York City enjoying occupancy way above the rest of the country - PKF expects NYC to bottom out at a 72 - 75% utilization rate, vs. the high 50s for the U.S. as a whole - rate compression is having a greater negative impact to REVPAR than occupancy declines. Perhaps even more interesting, Fox avers that half the decline in occupancy is actually denominator driven, i.e. it's not from slower travel trends it's from a greater number of available hotel rooms due to supply additions. I believe that this is a major reason why the Manhattan market is getting hit harder than the nation as a whole.

I did some hotel feasibility analysis work a couple of year's ago when the hotel boom was still inflating - fortunately we didn't build one. At the time, according to my calculations, there was a pipeline of new development that would have increased the number of rooms in Manhattan by 25 - 30% over the next 3 to 4 years. With the onset of the credit crunch, a fair amount of attrition of this pipeline took place as many projects failed to get financing. According to Fox, however, 10,000 to 12,000 new hotel rooms will open in New York City this year and next. That's on top of an existing 68,000 to 69,000 base, according to PKF's calculations. This equates to growth of about 14% to 18% (on top of significant 2008 deliveries), fueled by projects PKF sees as fully financed and likely to open.

New York is coming off an extraordinary period of 3 to 4 years where utilization was 85% or so and for the majority of the year Manhattan was "sold out". According to Fox, "No one had ever seen this before in any market." It is no surprise then that developers were happy to accommodate the market (pun intended). Please note however, that as in many corners of real estate, even novice hotel developers were given previously unheard of levels of leverage to work with. So despite the fact that New York City will trough at an occupancy rate that will be the envy of other markets in the U.S., I have to differ with PKF's outlook for 2010 and 2011. They are looking for Manhattan REVPAR to decline an additional 4% in 2010 (all in Q1), and an increase of 12% in 2011, driven by a resumption of rate increases. My guess is that 2010 will see double digit declines again, as more product comes to market and desperate new hotel owners slash prices to try to make their debt service payments. As for 2011, it's too far out for my radar, but my guess is if the economy cooperates there could be some recovery from a lower than expected trough. It is worthwhile to note that Fox reports year-to-date through March REVPAR is already down 28 - 29%, so the 2009 numbers are already looking hard to hit. As more companies do like Goldman Sachs, who now mandates that employees traveling to New York bunk at the Embassy suites, and more new hotels are delivered, I'm expecting second half room rate declines to accelerate.

As far as projects around town go: The Shangri La that was to be built at the old YMCA building on 53rd and Lex has reportedly been "tabled", while the Orient Express, that was to have been built at the New York Public Library (5th Ave and 42nd) has reportedly been "sidetracked". The Nobu downtown has reportedly been derailed completely by the Lehman bankruptcy. My conversations with a couple of brokers who have "off market" hotel listings indicates that deals that were supposed to have gone through a few months ago have fallen through and sellers are becoming more "flexible", but still looking for per key valuations that are outlandish in my book. I see these folks flexing much more in the coming months. If you built a zombie condo and have a big balance sheet, you can go rental, but what do you do with a zombie hotel? Especially with New York City hotel rooms that run on, shall we say, the anorexic side of petite. According to a Real Deal article, just out, Wells Fargo has reportedly filed to foreclose on 250 Bowery, a 63 unit hotel with $40 million plus in loans outstanding, putting the cost of the property at north of $630,000 per key, which ain't peanuts. In some cases, like that of the Jasper on Park Ave in the 30s, a zombie condo has morphed into a potential zombie hotel. Back in November, the developer told the Real Deal that a European investment group had signed a deal to convert the erstwhile condo development into a boutique hotel....yes they were going to gut 80 brand new condos to turn them into 200 hotel rooms. You see, the highest and best use of midtown real estate, was still naively believed to be hotel rather than condo, despite the developing travel weakness and abundant supply of hotel rooms coming on (these guys gotta start reading Urban Digs). Predictably, the European money never showed up. For anyone who cares, when I first looked at this deal I found that the lender of record was a big European bank, I couldn't tell from the filings if they were owed $51MM or $94MM. Either way I bet this one leaves a mark. If any more evidence of the coming hotel price debacle were needed, Sam Chang, the top developer of New York City hotels in terms of volume, recently seemed to display a change of strategy. Chang is a consummate land developer and hotel manufacturer. He generally puts together sites, permits them and builds them to order for clients. But in a break from past practice, Chang is reportedly going to hold onto a Holiday Inn he has in progress at Delancey and Suffolk street on the lower east side. My guess is his buyer walked and Chang has gone from trader to investor....don't ya hate when that happens. But hey, the hotel won't be done until late 2010, by the earliest. If PKF's current forecast is correct, Chang will undoubtedly have a buyer lined up by then.

One of New York's smartest hotel developers in my book is Richard Born, who has had his share of very successful developments in the city. One of the pearls of wisdom I heard drop from his lips last year regarding the cyclicality of the hotel business was "I don't particularly like to build hotels, I like to buy them from the guys who build them". I'm with you Rich.

As for how this impacts the New York City residential market, expect the collection of stalled semi finished construction eyesores to continue to pile up, particularly in otherwise "happening" neighborhoods. Fox at PKF avers that downtown will likely be hit hardest in terms of straight to bankruptcy new hotels, due to the significant amount of room capacity being added and the huge decline in Wall Street business levels. Of course, the fully constructed hotels that become bank REO zombies could become great homeless shelters, or maybe the city will come up with some other novel use for them.

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