The U.S. lodging sector is currently in the midst of a strong, broad-based recovery. Historically low supply growth coming out of the global financial crisis has led to record-high occupancy, which has driven higher average daily rates (ADR; see Figure 1) and strong revenue per available room (RevPAR) growth across both full- and limited-service hotels. Business demand, which represents roughly 75% of total lodging demand, has been supported by corporate profits hitting fresh highs. And leisure demand, which represents roughly 25% of total lodging demand, has strengthened on improving consumer confidence.
History tells us that new supply typically rears its ugly head eventually – and signs of new supply are indeed emerging in pockets of the hotel sector. But it is important to remember that not all supply is created equal. As long-term credit investors, our bottom-up approach focuses on identifying companies within sectors and industries with relatively high barriers to entry, which should help drive above-average long-term earnings power and ultimate protection of principal.
While the past five years have seen significant occupancy gains for hotels, we believe the next phase of the recovery will be characterized by rate growth. We see opportunities in certain segments of the hotel sector – such as the premium end of the market – due to high barriers to entry and pricing power. We believe these segments are better positioned to survive an eventual downturn and thrive coming out of it.
Will new supply crash the party?
Barriers to entry in the hotel sector typically refer to the ability of market participants to add new supply, as well as to the pace of new supply additions. New hotel room growth is forecast to remain historically low over the next two years (see Figure 2), but the picture becomes less clear slightly further out. Eventually, development yields on new deals will begin to make sense in some markets and for some product types given the recovery in RevPAR, attracting additional capital to the sector. Positively, however, new hotel supply has mostly been surfacing in markets where local economies are relatively strong and demand has been able to absorb supply, such as New York City and Seattle.
Additionally, much of the new supply expected to come online over the next few years is concentrated in the mid-tier segments of the market (see Figure 3), which have fewer land constraints and shorter construction timeframes.
What about other risks?
“Shadow” supply stemming from disruptive sharing services such as Airbnb will also become increasingly prevalent. While room-sharing will likely take some market share from traditional hotels, we think this will have more of an impact on leisure travel, rather than the much larger business travel segment. We believe business travelers will continue to favor traditional hotels given convenience to conference venues, meeting space and amenities.
Pandemics, such as the Ebola scare, could also put a dent into favorable hotel trends. However, based on the data before, during and after the peak of the Ebola-related headlines in the fall of 2014, hotel RevPAR growth did not slow down, and even accelerated from prior months. Additionally, prior virus outbreak scares, including H1N1 and SARS, proved to be very short-term in nature and isolated to select markets where the scare was present. For example, RevPAR growth fell materially (down 40%–80% year-over-year) in Hong Kong and Toronto during the SARS scare and for a couple of months afterward, but began to recover once health officials gave the “all-clear” signal. In total, significant RevPAR growth declines lasted for about six months in each city.
We continue to favor lodging C-corps over the long term
From a credit perspective, we continue to view lodging C-corps (companies whose income is taxed at the corporate level, unlike a REIT, whose income is not taxed as long as 90% of its taxable income is distributed to shareholders) as an attractive area of investment. Most of these companies have shifted toward asset-light operating models, whereby an increasing percentage of EBITDA (earnings before interest, taxes, depreciation and amortization) is generated from highly scalable management and franchise fees (see Figure 4), which require very limited capital expenditures (capex). These companies differ from hotel REITs, which own the physical real estate and are therefore responsible for both maintenance and redevelopment capex. Owners of physical hotel assets spend roughly 2x–3x more on total capex compared with other commercial real estate property types due to the wear and tear associated with daily turnover of hotel rooms, as well as the need to refresh rooms and common areas over longer time horizons. While there are always exceptions, such as the potential for exceedingly above-average RevPAR growth or cap rate compression, which would drive above-average hotel asset value appreciation, these high capex levels generally eat into the long-term returns of owning and holding physical hotel assets over longer time horizons and through cycles.
Overall, while hotel demand remains highly sensitive to the economic cycle given “daily leases,” lodging C-corps tend to generate significant free cash flow and carry very low levels of debt, resulting in favorable credit risk profiles.
We see the premium end of the market as attractive over the long term
New supply in the upper-upscale and luxury segments in particular has been, and should remain, minimal across the country for the foreseeable future. This is due to the increasing difficulty finding attractive land to build on within the major lodging submarkets, the high absolute costs and lengthy construction timelines of building luxury hotels, and a more disciplined construction financing market characterized by lenders requiring more equity from sponsors and offering financing only to sponsors with solid track records.
Building brand awareness and customer loyalty is also a significant headwind for potential new entrants into the space as customers get accustomed to a certain level of brand standards, service and consistency at the hotels they stay in, as well as favor hotels within their rewards systems.
Therefore, we generally favor the premium end of the market, which we view as a high-barrier-to-entry segment of the hotel sector that provides relatively more attractive investment opportunities over longer time horizons.
Overall, we continue to have a positive view of the hotel industry. Despite some incremental supply entering the system, occupancy levels should remain relatively high, which should drive continued favorable rate growth over the next several years.