Despite Age-Old Risks, Opportunities Abound in the Hotel Industry

By Rushmore, Steve | Real Estate Issues, Winter 2006 | Go to article overview

Despite Age-Old Risks, Opportunities Abound in the Hotel Industry


Rushmore, Steve, Real Estate Issues


FOCUS ON HOSPITALITY

Editor's note. This article is excerpted from the presentation Steve Rushmore delivered during the 2006 CRE Annual Convention, Oct. 21 - 26 in Maui, Hawaii. Read more conference coverage in most recent issue of The Counselor newsletter (published January 2007) and at www.cre.org/programs_and_events/annual_convention.cfm.

GENERALLY IT'S A GREAT TIME TO BE IN THE HOTEL BUSINESS-and a great time to be consulting in hotels-because everything you say is upbeat and good. No matter where you are in the world, it's almost universal that the hotel industry is doing well, particularly in the United States.

But there's always risk. Some of the major risks of investing in hotels are over-building, economic lifespan and natural disasters. We'll touch upon each of these issues briefly.

The first risk is over-building. People say the best thing for a hotel is location, location, location. I say it's barriers to entry, barriers to entry, barriers to entry. You want to be in a location where the competition isn't going to build another hotel. In the United States this could be anyplace on the coast, especially in California and the Northeast. The Southeast is not as good-it's very easy to get things built down there.

If you look at any of the downturns in the hotel industry, they're because of over-supply. The reason the hotel industry is doing so well now is because the supply has been in check for about the last five years. It doesn't look like we're going to get a whole lot of new hotel supply coming in on a macro basis in the United States. Some markets will get over-built, but for the most part it's pretty well under control.

A number of factors have led to this situation. First, it's very difficult to finance new construction in the hotel industry today. The cost of building a hotel, particularly a five-star hotel, is another barrier to entry because the chances are good that the developer could end up with a hotel that costs more than its economic value.

THE BATTLE AGAINST OBSOLESCENCE

Then we have economic lifespan, or the fact that hotels suffer from physical deterioration, external obsolescence and functional obsolescence. Take, for example, the original Waldorf-Astoria Hotel built at Fifth Avenue and 34th Street just before the turn of the 19th century. It was torn down to build the Empire State Building only 34 years later. So the original Waldorf-Astoria in New York lasted less than four decades. It was moved over to Park Avenue and has been there ever since, but what's interesting is the concept of economic life.

My company verified a study that found the economic life of most hotels is about 41 years. That sounds fairly reasonable, but consider the standard deviation. That is the risk of investing in hotels (see Table 1). You don't know within one standard deviation whether your life is going to be 20 years or 60 years. Therein lies the problem.

Other significant problems are external and functional obsolescence. Motel-type properties built through the decades are rather obvious. The exteriors really date the properties, which means hotels that are more than 20 to 30 years old need major external renovation.

When you go inside the hotel you can also date it by what the décor looks like. When you really think about it, has the interior of a typical hotel room changed? You walk in, you have a bathroom on the left, a closet on the right. You walk in a little bit farther and have a bedroom with a bed and dresser and table and so forth. Things haven't really changed; what changes is the décor. Maybe it's a conspiracy of interior designers to constantly change the style of hotels, but this is the reality that hoteliers face so they have to constantly put money back into their properties.

NATURAL DISASTERS CAN BE A BOON TO BUSINESS

The industry has experienced many hotel disasters recently. In New York City, the Sept. …

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