Inflation, Interest Rates Further Hamper California Hotel Development

Conversions of Hotels to Other Uses Likely To Result in Declining Rooms Supply

https://www.costar.com/article/71236614/inflation-interest-rates-further-hamper-california-hotel-development

The Luma Hotel San Francisco was the largest hotel to open in California during the first half of the year with 299 rooms. (Nathaniel-Mark Bernardo/CoStar)
The Luma Hotel San Francisco was the largest hotel to open in California during the first half of the year with 299 rooms. (Nathaniel-Mark Bernardo/CoStar)

While developing a new hotel in California was already a challenge, the lasting effects of the pandemic and rising costs to build and finance projects have further hampered development in the state.

Atlas Hospitality Group’s California Hotel Development Survey 2022 Mid-Year reports that 29 hotels opened in the first six months of this year, a 43% year-over-year decrease. The number of new rooms opening dropped from 7,168 to 3,561, a 50% decrease. The largest hotel to open was the Luma Hotel San Francisco with 299 rooms.

The number of hotels that are under construction decreased by 12%, from 132 to 116. The number of new rooms under construction fell 11% from 17,962 to 15,958. The largest hotel in the state under construction is the Gaylord Bayfront Chula Vista in San Diego County with 1,600 rooms.

The number of hotels in the planning stage remained relatively stable compared to 2021 with 1,248 this year against 1,240 last year. The number of rooms in the planning stage dipped slightly to 162,831 from 163,904.

The openings numbers come at a contrast to the year-end development figures, which showed a rebound in development, but many of those openings in 2021 were the result of projects delayed from 2020.

Moving into the second half of the year, Atlas Hospitality Group President Alan Reay said he expects many projects will be put on hold if they haven’t already started construction. Lenders are taking a bit of a breather from new hotel construction financing, plus developers still face supply-chain disruptions and escalating costs of materials and labor.

Reay said more projects have been deferred or abandoned during the first half of this year than he has ever seen before. It’s a matter of the availability of financing, supply constraints, uncertainty of the industry and costs. He expects the number to increase through the year.

There have also been several projects that have stalled mid-construction, primarily in the Coachella Valley in the Greater Palm Springs area, Reay said. There’s a project in Orange County that was under construction that went through bankruptcy, and the construction site is still closed down.

Declining Supply

While he expects to have a full count by the end of this year, Reay said he expects California will be one of the few states with a reduction in rooms supply. It’s a combination of both a lower number of new hotel openings with the volume of hotel deals that are taking rooms offline to convert the hotels to other uses, mostly for apartments and housing for the homeless.

“We’re definitely in a situation in California where we’re not adding new supply, we’re declining,” he said.

California saw a similar decline in supply in 2020 due to slowed development, delayed openings and hotels conversions.

A major factor in that is Project Homekey, the state’s program to fund hotel purchases by local and county governments to convert to housing for the homeless, he said. While the project ran into some tough questions over pace and pricing last year, it received another $3.5 billion in the latest budget and has been seen as a success.

From the government’s perspective, the cost of new government construction projects is roughly $500,000 per unit, but they can buy these existing hotels for much less, he said.

There’s a lot of pressure on cities to provide affordable housing, and that’s leading local governments to pivot in how they handle conversion requests, Reay said.

“Anyone that approached the city to convert an existing hotel to apartments was pretty much turned down because the cities need the transient occupancy tax that hotels provide,” he said, adding they would also have to change zoning laws as well. “Now cities are desperate to provide affordable housing, and hotels are sort of the easiest and quickest way to do that.”

The one segment in particular that’s the target for conversions for housing is the economy segment, further decreasing the supply with little chances of new development, Reay said.

“If there’s anything close to a monopoly today in California, it’s those hotel owners that are in the budget segment because nobody can afford to build a budget hotel today,” he said.

New-Build Hotels

The most common hotels being built are branded select-service hotels, Reay said. For a 120-room Hilton Garden Inn or Courtyard by Marriott, the timeline from breaking ground to cutting the ribbon is about 18 months, subject to supply-chain constraints. That’s about three to four months longer than the historical average.

The time to build a full-service hotel is at least two and a half to three years when it used to be about two years before, he said.

Some developers have turned to modular construction, mainly for select-service hotels, Reay said. While that’s not necessarily less expensive, it does save time during the construction process, taking about 12 months start to finish. However, there’s still a timing issue over when the modular components will be available.

The extended-stay and even upscale select-service properties aren’t as risky of a build as full-service properties, Reay said. It’s a more expensive and longer build process, especially in California, and there are fewer buyers for these types of hotels.

“The question is, how long a lead time before meetings get back to pre-COVID time,” he said. “Seems like not a day goes by people aren’t talking about staff shortages, staff expenses. The profit margin for a full-service hotel versus a limited-service hotel doesn’t leave a lot of margin for error.”

For development of an independent hotel, it comes down to the availability of financing, Reay said. As successful as independent boutique hotels have been, particularly with soft brands, most lenders still feel more comfortable with the major brands. Obtaining financing would likely require having a strong record of success with these types of hotels.

For a new developer wanting to develop an independent property, even if aligned with a hotel management company, lenders who get involved will require the developer to put much more equity into the deal than normal, likely 50%. The project will also be under much more scrutiny as well.

Most of the adaptive-reuse projects in California now are turning hotels into something else rather than the other way around, Reay said. The only other product type that makes sense for adaptive reuse into a hotel is an office building, and those are more likely to be found in downtown locations. However, the hotels in downtown areas of major markets such as San Francisco and Los Angeles continue to struggle, so developers are more likely to turn those buildings into apartments.

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