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Containing euphoria: where are we in the cycle?

Coming off a remarkable year of growth, participants in the U.S. hotel industry are in a state of euphoria. According to Smith Travel Research (STR), hotels in the major U.S. cities enjoyed a very strong 12.4 percent gain in RevPAR in 2005, the biggest growth rate recorded since 1979. With large increases in both occupancy (4.1 percent) and average daily rate (8.0 percent) driving the extraordinary gain in RevPAR, PKF Hospitality Research (PKF-HR) estimates that hotel profits grew in excess of 20 percent for the year. This level of profit increase is the greatest observed since 1978. Based on all these measurements, 2005 can be declared as one of the best years of performance for U. S. hotels in the past quarter century.

Yet, as we know, lodging is a cyclical industry. Most recently, the high times of the late 1990s were virtually eliminated by the losses sustained from 2001 through 2003. In fact, the typical U.S. hotel is still two years away from achieving the same level of profits they did back in 2000.

Experience reveals that record-breaking growth cannot be sustained in perpetuity. Relatively strong performance compared to other forms of real estate could attract "irrational" investment and stimulate the construction of hotels that are beyond what are immediately needed. Alternatively, a catastrophic weather or terror related event could quickly cut the demand for lodging accommodations. The most likely scenario, however, is that the natural economic laws of supply and demand will eventually take over. Profits and values will reach the levels needed to make development financially feasible, thus creating new competition and lowering occupancy rates. In addition, people will alter their travel plans if hotels become too expensive, thus limiting growth in ADR.

When will all this occur? To answer this question, we have examined where the U. S. hotel industry is on the long-term business cycle.

All Enjoyed 2005

As mentioned before, 2005 was a year of exceedingly strong growth in both revenues and profits. Fortunately, it appears that this strong growth was enjoyed all across the nation by all types of hotels. Full-service hotels achieved a 12.0 percent gain in RevPAR in 2005, the result of a 3.4 percent increase in occupancy and an 8.3 percent jump in room rates. Limited-service hotels saw their occupancy rates rise in excess of 5.0 percent for the second year in a row. With limited-service average room rates growing 7.7 percent, RevPAR for this segment was able to increase 13.3 percent in 2005.

Looking at hotel performance around the country, four of the five regions enjoyed RevPAR growth in excess of 12 percent. The lone exception was hotels in the North Central region where RevPAR grew just 8.0 percent. Hotels in the South Central region lead the nation in RevPAR growth at 15.5 percent. While the New Orleans market was eliminated from our analysis, displaced demand sent to markets such as Austin, Houston, Memphis, Dallas, and Fort Worth helped to drive regional occupancy up 9.6 percent in 2005.

Moderation In 2006 And 2007

Based on the Spring 2006 Hotel Outlook forecast developed jointly by PKF-HR and Torto Wheaton Research, industry growth rates are expected to slow down in 2006 and 2007, thus indicating an approach to the peak of the current industry recovery cycle. Over the next two years, occupancy rates are forecast to grow at an average annual rate of 0.5 percent, while room rates should increase at 3.9 percent. The net result is average annual RevPAR growth of 4.5 percent from 2006 through 2007.

Coming off two years of 10.0 percent and 12.4 percent RevPAR growth respectively in 2004 and 2005, the 4.5 percent growth rate forecast for 2006 and 2007 appears to be conservative. Should this be interpreted as a forecast of poor performance?

The answer is no! In fact, the average annual growth rates for occupancy, ADR, RevPAR, and demand for the next two years are above the historical long-term averages posted from 1988 through 2005. The only 2006-2007 growth measurement that is below its long-term average is the forecast change in supply, which is indicative of the relative lack of new hotel rooms anticipated to open in the next two years.

Since you can't take percentages to the bank, it is important to also look at the absolute values of the performance measurements. The Spring 2006 Hotel Outlook forecast projects a 68.7 percent occupancy rate of major U.S. city hotels in 2006. This is the highest occupancy level recorded since 1997, and surpasses the occupancy rates achieved in 15 of the past 18 years. Meanwhile, hotel room rates are forecast to end up at $110.66 by year-end 2006, the second consecutive year that room rates have surpassed the $100.15 mark achieved in 2000. With occupancy and ADR levels approaching long-term highs, the 2006 forecast is both an indicator of current strong performance and a sign that we are nearing the top of the current business cycle.

City Cycles

As we have mentioned many times before, it is vital for hotel owners and operators to analyze city specific measurements since local market conditions and economic factors have the greatest influence on an individual hotel's performance. Therefore, it is important to understand where each hotel market is at in their respective business cycle.

Comparing forecasted growth rates for occupancy, ADR, RevPAR, supply, and demand to long-term historical averages, we find that the location of each of the 52 markets in our forecast sample on their respective business cycles varies.

As shown in Exhibit One, the vast majority of markets are expected to see less development activity occur in 2006 and 2007 than has happened on average over the past 18 years. At the same time, roughly half are expected to realize demand growth that will be less than their historical average.

Driven mainly by limited amounts of new supply, a majority of cities in our survey sample will see occupancy gains greater than their historical average. Due in part to the relatively strong growth in occupancy, hotel managers in 60 percent of the cities should be able to push their room rates.

A Soft Peak

As we approach the peak of the current recovery cycle and then the inevitable "downturn" on the other side, PKF-HR is optimistic that the eventual fall-off in performance will not occur soon and be as dramatic as those seen in the past. The underlying fundamentals of the economy, as well as current practices of industry lenders, developers, and operators, point to a near-term operating environment of sustained levels of high performance with only moderate variation in the years ahead.

The looks of business cycles are frequently analogized as roller coasters. The historical "Big Cyclone" model for the hotel business cycle is being replaced by the "Kiddy Coaster".
Exhibit One
Comparison of Historical (1988-2006) Average Annual Change
To Forecast (2006 and 2007) Average Annual Change

 Number of Markets

Performance Forecast Change Lags Forecast Change Leads
Measurement Historical Average Historical Average

Occupancy 20 32
ADR 21 31
RevPAR 20 32
Supply 40 12
Demand 28 24

Sources: Smith Travel Research, Torto Wheaton
Research, PKF Hospitality Research
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Publication:Quarterly Trends in the Hotel Industry (USA)
Date:Mar 1, 2006
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