"What has once happened will invariably happen again, when the same circumstances which combined to produce it, shall again combine in the same way."

 Abraham Lincoln, Springfield, Illinois, December 26, 1839.

When contemplating these sage words uttered by Lincoln over 175 years ago, we once again asked ourselves the question:  are the historic market conditions that stimulated new construction in the past now appearing on the horizon?  If so, are we likely to see overbuilding in certain markets and/or of certain property types as we have traditionally seen during past lodging recoveries? Or are the market fundamentals different this time such that the equilibrium point at which new hotel development is warranted has shifted?  The short answer is…..perhaps!

The flow of investment capital into the U. S. lodging industry dramatically increased in 2004, and expectations are for more of the same during 2005 and beyond.  Key drivers of this market behavior include:

• The juxtaposition created by the highs of the dot.com bubble of in the late 1990's and the lows of the post 9/11 period created levels of market uncertainty that were arguably unprecedented.  The ensuing series of world-events ran their course through mid 2003, and investor sentiments remained subdued as supply growth trickled to a virtual halt.
• Since the third quarter of 2003, demand growth in most markets started to accelerate, and occupancies began to recover.  While the revenue transfer from property owner to the online intermediaries served to mute the return of pricing power that traditionally comes with sustained occupancy growth, average daily rates began to accelerate in the second half of 2004.
• In 2004, occupancy and rate growth resulted in a 7.6 percent increase in unit-level hotel revenues, which in turn led to an 11.4 percent increase in profits for the year, thus ending a three-year decline in industry profitability.  Given the strength of industry fundamentals, profit growth should continue to be considerable at least through 2006.

Demand levels begin to expand - occupancies increase – room rates accelerate – profits go up – investors move to buy existing assets - - developers start to build?  Normally the answer is yes!  However, several current market factors critical to the economic justification of new construction suggest that the answer may still be no.

• Perhaps most revealing is that the nominal level of Profits per Available Room (defined as income before capital reserves, debt service, rent, income taxes, depreciation and amortization) in 2004 was roughly the same as in 1996. Interesting, 1996 represented the year in which supply growth began to accelerate dramatically, a condition that characterized the U.S. lodging industry for the balance of that decade.  In fact, based on data compiled by Smith Travel Research, the national annual increase in available lodging supply during the period 1996 through 2001 was almost exactly two (2) times the level of annual supply growth for the preceding six year period.  We will not see such a run-up in supply during this recovery.  Based on data developed by the Bureau of Labor Statistics, the Consumer Price Index increased by over 20.0 percent from 1996 through 2004.  The current outlook for U.S. profitability growth is substantial; however, it will likely not be until the end of this decade that profits have fully recovered in real terms.
• The challenge to developers created by the need for a return to profitability in real terms is further complicated by the dramatic increase in land prices and certain key construction materials such as steel, concrete, and wallboard.  Land values have been driven up by the strong housing markets in many areas of the country, a phenomenon that may be attributed to shifting domestic demographic conditions and the notion of an "ownership society".  Demand for steel and concrete from emerging markets around the world, particularly China, have far out paced available supply, and significant price increases have resulted. These trends raise the "cost bar" for hotel development.

While the strong flow of capital into U.S. lodgings has served to escalate hotel property values significantly since 2002, they have yet to reach replacement levels in most markets.  The atypically large spread between market values and replacement costs, caused by the decline in real hotel profit levels while construction prices grew dramatically, will likely persist through 2006. 

As such, building will be difficult for most developers in the near term, and investment dollars will continue to seek existing assets.  Rest assured, however, that the cycle will continue to evolve and shovels will be breaking ground in significantly larger numbers well before the end of this decade.  Thus, as Lincoln noted, "what has happened will invariably happen again", only this time a little more slowly than usual.

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R. Mark Woodworth is Executive Managing Director of PKF Hospitality Research.  He is located in the firm's Atlanta office