High Barriers To Entry Make Construction Harder To Justify Financially

By Bryan Wroten | Hotel News Now | January 19, 2024 | 6:28 AM

A new law in Los Angeles could have a dramatic effect on hotel development in the city — that is, if hotel developers didn’t already feel constrained by the overall environment there.

In early December, Los Angeles City Council passed its Responsible Hotels Ordinance to require new hotel development projects to replace any displaced housing units on a one-for-one basis. The ordinance is aimed at prioritizing affordable housing over new hotel developments in the city.

The ordinance was a compromise between the city council and Unite Here Local 11, a labor union that represents hospitality workers and that has been advocating for more affordable housing in the city. In passing the new ordinance, the council officially rescinded a March 2024 ballot initiative backed by Unite Here that would have required hotels to make vacant rooms available to the unhoused. The new ordinance also directs the city to create a voluntary registry for hotels to notify the city about vacant rooms available as interim housing.

The prospect of having to replace housing that is demolished or converted for hotel use is just another deterrent to developers, whose interest in building in Los Angeles was already low.

“When we’re talking about the city of Los Angeles, it was already down to zero, and now this is minus,” said Alan Reay, president of Atlas Hospitality Group, a real estate brokerage that focuses on California hotel deals.

Solid Performance, Uncertain Conditions

CoStar data shows that the Los Angeles hospitality market in December posted year-to-date growth in occupancy, average daily rate and revenue per available room. The 12-month average ADR was $198 while RevPAR was $142, each near historical peaks. The 12-month average occupancy through December was 71.7%.

As of early January, the city of Los Angeles had two hotels in construction with eight in final planning and another 21 in planning, according to CoStar pipeline data. Eight projects are listed as deferred.

The Los Angeles market itself is performing well, said Emmy Hise, senior director of hospitality analytics at CoStar. Occupancy continues to grow, while rate growth has slowed, but some of that is due to year-over-year comparisons to 2022, when the market hosted the Super Bowl.

The Hollywood, Beverly Hills and Santa Monica areas have some of the highest rates in the overall Los Angeles market, but those are starting to fall from peaks to more normal levels.

“I feel like the best way to describe the LA market for hotel performance is stabilized,” she said. “I don’t expect a huge decline or a huge ramp, just kind of normal 1% to 2% growth.”

Los Angeles will host the Super Bowl again in 2027 and then the Olympic Summer Games in 2028. But despite its stability and events calendar, the newest ordinance and other real-estate-targeted laws create uncertainty for developers, she said.

“It’s already a difficult time to underwrite and get things to pencil,” she said.

The “mansion tax” places a 4% tax on all property sales exceeding $5 million. For sales over $10 million, the tax rate is 5.5%. The tax went into effect in April 2023, and in August City Council approved a plan to spend $150 million raised by the tax on affordable housing.

In 2023, only four of the roughly 30 hotel deals in the Los Angeles market were valued at more than $20 million, according to CoStar data. Since the mansion tax went into effect, only four hotels have traded in Los Angeles, three of which were planned for conversions, so they were exempt from the tax. The fourth was for $3 million.

Most hotel developers are leveraged up to 60% to 70%, Reay said, and these taxes add up along with closing costs and commissions, he said.

“It’s just a huge amount of equity that goes out of the deal,” he said.

The previous combination of laws that fit into the entitlement process already made Los Angeles a difficult place to build new hotels as it takes a long time to get permits in place, Hise said.

“To have these additional hurdles is just going to make it that much more difficult,” she said.

Hotel projects can stay in the planning and final planning phases for years before moving to construction because it can take that long to receive city approval, she said. Even once a project breaks ground, it can take years because of the lack of availability of construction labor and city inspections.

The developers Reay works with have told him that there are so many other possible locations within California, and in the U.S., to build so they don’t have to deal with this, he said.

There’s a great amount of interest in the cities directly outside of Los Angeles, where these laws aren’t in play and travelers still have access to attractions in Los Angeles, he said. The coastal cities, however, have their own particular challenges for new construction.

The upside is that high barriers to entry mean owners of existing hotels will enjoy the market’s improvement without worries about new supply coming in, Reay said.

“They’re going to enjoy better revenues and better profits because not only are we not going to get any new construction, we’re still seeing the city and state purchasing up hotels for homeless housing and then other developers purchasing up hotels to convert to affordable housing,” he said.

A Developer’s Perspective

Newport Beach, California-based hotel developer RD Olson Development bought a Jack in the Box site in Hollywood in 2016 to tear down and build a 255-room hotel with a rooftop lounge, said Bob Olson, president and CEO of the company and CEO of RD Olson Construction. The development ran into challenges raised by unions and neighbors, including: shade and shadow, traffic, construction noise complaints, card check neutrality and union construction promises.

After all that, there are newer work rules limiting how many square feet housekeepers can cover, annual police department permitting for new hotels and now the mansion tax, Olson said. 

“The weight of all that together, it just crushes,” he said. “It doesn’t make economic sense anymore, and so there’s no new hotel. That’s what happened to us. We ended up selling it and got out of it. … The problem is, it’s not just one cut. It’s death by 1,000 cuts.”

Olson said he doesn’t know how to make a new hotel project in Los Angeles pencil. A hotel his company invested in is now worth less than when it was acquired five years ago, but there’s no way out now with the new mansion tax.

Olson said he loves Los Angeles and California overall. A native Californian, he said he has no plans to leave the state, but his company is looking at development opportunities elsewhere. The company is active in Arizona, Texas and Nevada because that’s where demand, and RevPAR, is rising.