Why fixing the economy means bad news for hotel rates

Historically high hotel rates — in this economy?

Get used to it, folks.

Hotel companies during the pandemic advised hotel owners to keep rates at relatively normal levels, as discounted rates wouldn't incentivize people to book a stay during a health crisis and lockdown. That enabled hotel companies to bounce back from pandemic lows far quicker than in any prior downturn.

But with the economy in uncertain territory these days, surely the old playbook of discounted rates must be under consideration, right?

Wrong.

The Federal Reserve's efforts to curb inflation involve hiking interest rates, including a 0.25% hike just this week. That makes it more expensive to borrow money to build things such as real estate developments, including hotels.

Even in the best circumstances, hotel construction in the U.S. is a tall task, given high construction costs on materials and labor and supply chain issues that have delayed many projects. Any headwind on the construction front means less new supply hitting the market.

Shrinking supply on top of improving demand drivers like international and business travel means higher hotel rates are likely to stay.

For example, construction on Dream Las Vegas, part of Hyatt's recently acquired Dream Hotel Group division, halted this month amid stalled financing plans, the Las Vegas Review-Journal reported. The developer behind the hotel blamed rising interest rates as a part of the reason for the construction delay.

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Additional instances of this can exacerbate the situation. Fewer hotel rooms coming to market amid recovering demand levels means rates will only go higher.

"We continue, from a fundamentals of the industry point of view, to feel very good about things. It's the fundamentals [of] supply and demand — that's what ultimately drives the result," Hilton CEO Christopher Nassetta said last month about hotel pricing on the company's fourth-quarter earnings call. "The supply side is quite muted. We're currently experiencing — using the U.S. market, which is our biggest market, as an example — equal to the lowest levels of supply that we've seen."

Waves of layoffs in the tech industry, a banking crisis and anxiety over inflation paint a grim economic picture, but the hospitality sector continues to thrive.

Along with being a leading source of job creation for the last several months of better-than-expected jobs reports, hospitality companies reported massive 2022 profits during the most recent earnings season. Major hotel CEOs seemed to marvel at the ability to charge higher rates, and it doesn't seem like the trend is dissipating with uncertainty in the financial markets.

Luxury hotels in the U.S. last week performed more than 24% above 2019 levels, according to STR data. Overall U.S. hotel performance was 10.4% above 2019.

The case of the vanishing hotel rooms

Don't look for relief in the form of new hotels opening to arrive anytime soon.

"Even before higher interest rates and the banking crisis, new hotel supply has been fairly muted on a relative basis," said LW Hospitality Advisors CEO Daniel Lesser. "Now, eight to nine months later, with rising interest rates and the banking crisis, it's going to be a challenge to obtain financing even for operating hotels making money. It's going to be that much harder to button down construction financing for a new project."

While there have been signs hotel construction began to slightly improve this year, the overall U.S. hotel construction pipeline of rooms actively under construction isn't back to pre-pandemic levels.

Hotel companies might point to growth, but that's partially assisted by conversions — deals where an existing hotel owner agrees to convert their property to new branding. That usually doesn't add more hotel rooms to a market. Sometimes, it even means reducing the room count.

Further, a significant number of hotel rooms left the system altogether during the pandemic, as many owners redeveloped hotels into alternative uses. This ranges from smaller hotels getting converted to housing to larger ones, like New York City's Hotel Pennsylvania, getting demolished for new real estate development.

"We're still seeing a fair amount of older, functionally and physically obsolete hotel [products] being converted either to alternative uses or scrapped for new development," Lesser said. "The CEOs are spot-on that new supply is muted and is going to continue to be muted, and that's only going to put upward pressure on pricing power."

Is any relief in sight?

Rome wasn't built in a day, and neither are hotels. Surely, there must be some kind of relief down the line for travelers. After all, leisure demand remains high, and the business, group and international travel sectors are coming back. Strong demand drivers usually incentivize developers to move forward on new hotel projects to meet that need for more rooms.

Hotel companies might point to slight upticks in their respective sizes over the year, but it's still likely not enough to make a dent in soaring room rates — particularly at higher-end hotels.

"There's definitely not a glut of new supply," said Patrick Scholes, managing director of lodging and leisure equity research at Truist Securities. "There are definitely some cities where there's a lot of new supply [like Nashville and New York]. But for the most part, there's very minimal, if any, new supply. Where you do see supply is going to be ... your midscale brands, many of them Hilton or Marriot types of brands, or even Wyndham's new Echo brand."

High interest rates might eventually bring down inflation, but they aren't conducive to hotel deal-making and getting shovels in the ground.

Few deals got made and "transaction volumes for European real estate have fallen off a cliff as investors have struggled to underwrite deals in the face of an uncertain outlook on rates," says a Bloomberg report from MIPIM, an annual conference for the global commercial real estate sector held earlier this month in Cannes, France.

One of the few deals announced during the conference was the purchase of a Pullman hotel in Cannes, but that's an existing asset — not exactly the sign of new construction ushering in more European hotel supply that brings rates down for your summer vacation.

Both the heads of the Fed and the European Central Bank noted in recent remarks that bringing inflation down is their top priority. Raising interest rates is their main tool to do just that.

If commercial real estate remains paralyzed by high interest rates, the tension in the travel sector will remain: Plenty of people still want to stay in hotels, but developers don't have the financial tools to build more supply to meet that demand.

Until that changes, it remains a scenario where it's great to own a hotel — and not so great to be the one paying the nightly rate.

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