It’s been a wild ride but industry fundamentals are finally back to 2000 levels

The year was 2000, and amid speculation and hype about the new millennium, the hotel industry was celebrating its strongest year on record. Seven years, and a couple of watershed events later, hoteliers can finally push the rewind button — industry performance has returned to the halcyon days prior to 9/11. By all indications, 2006 was a banner year.

“We saw a four per cent demand growth nationally, offset by only a two-per-cent increase in supply,” says Brian Stanford, director of Toronto-based PKF. That growth translates into a two-point improvement in occupancy, a four-per-cent increase in ADR and a six-per-cent increase in RevPAR. At the end of the day, however, it’s the double-digit growth in profitability (currently sitting at 13 per cent) that’s putting smiles back on hotel owners’ faces. 

Ironically, while there has been a significant decline in the number of American visitors travelling to Canada (in part, because of a high Canadian dollar and the introduction of the WHTI), industry profitability in 2006 sits at $10,600 per room, almost back to 2000 levels of about $11,000. Canada’s strong overall economy (outpacing the performance of all other G7 countries), spurred by the continued boom in Western Canada and spinoffs from the oil industry, fuelled much of the growth of the past year.

“The resource sector has had a significant impact on the accommodation industry in Western Canada, and as result of strong demand growth, ADR has grown,” says Stanford. This rate growth is the primary contributor to the improvement in industry profitability, which grew by 16 per cent in 2006 in Western Canada — higher than national 2000 levels by more than 10 per cent. “Bottom lines are expected to increase by a further six per cent this year,” says Stanford.

According to Colliers International Hotels, investment in the Canadian hotel sector last year was booming, reaching aggregate transaction volume of almost $3 billion, the highest hotel level ever recorded. “Cap rates are at an all time low and there is a high level of debt and equity looking for investment opportunities,” adds Betsy MacDonald, managing director of Vancouver-based HVS International.   

A total of 141 hotels exchanged hands in 2006, up 73 per cent from 2005. Making headlines were the Fairmont sale to Kingdom Hotels International and Colony Capital LLC, and its subsequent shedding of real estate assets to Oxford Properties/Ontario Municipal Employees Retirement System (OMERS), and the purchase of Four Seasons Hotels & Resorts by Kingdom Hotels and computer guru Bill Gates. “There are good quality hotel assets available for sale in Canada that are attracting the attention of global investors, especially from the U.S.” says MacDonald. “The lack of product available in the U.S. and the large number of investors chasing deals bode well for Canadian operators.” Additionally, liquidity in the capital markets spurred the formation of two new Canadian hotel REITs (Holloway Lodging and Lakeview Hotel).

The future bodes well for the continued health of the market, but are industry analysts worried about transitioning into the downward stage of the cycle? “The issue of the cyclical nature of our industry is somewhat misleading,” says PKF’s Stanford. He believes the dramatic decline in industry performance during the early ’90s had as much to do with overbuilding as with a softening economy. “Throughout the early ’90s when industry profitability hit an all-time low, demand and occupied room nights still grew, albeit at modest rates. It was the advent of significant new supply, and the industry reacting by decreasing ADR, that really contributed to the erosion of profitability.”

Still, the strength of both the U.S. and Canadian economies will determine how long this cycle lasts. “The stronger Canadian dollar could further impact tourism and the manufacturing sector,” says Joel Rosen, principal of Horwath International in Toronto. “That would weaken the economy and impact the hotel industry, particularly the commercial transient business.” But he’s confident the cycle will continue its run “unless there’s a dramatic change or [external] shocks to the economy.”  

Barring such events, the outlook appears solid through 2012. “Demand continues to outpace supply growth in most markets allowing hoteliers to increase average room rates,” says HVS’ MacDonald. For many hoteliers, the introduction of the WHTI and its impact on American travel will be the biggest uncertainty, especially in resort areas. And if you happen to own a hotel in Alberta or Northern B.C. you’ll be losing sleep over looming labour shortages, which may mitigate your ability to achieve the same growth as last year. 

Nevertheless, most industry analysts aren’t perturbed. “We’ve seen the supply cycle holding between 1.5 per cent and 2 per cent per annum, and if this continues there should be reason for optimism,” says Stanford. That’s not to say specific markets and assets won’t be impacted, but overall, the supply/demand balance of the industry should remain strong. PKF’s outlook for the industry calls for a six-per-cent increase in profitability this year, returning the industry to 2000 levels, with a further 13-per-cent increase over the balance of the decade (2008 thru 2010).

The industry has the potential to achieve strong ADR growth. PKF’s base industry outlooks reflect above-inflationary rate increases over the next few years. “However, with national occupancy projected at 66 per cent this year, and with demand anticipated to continue outpacing supply, the industry has the potential to move rates far more aggressively,” says Stanford. “We saw clear evidence of this in Western Canada in 2006, where ADR was up more than six per cent.” 

However, resort owners may not be as fortunate. “We’ve already seen significant erosion in the resort segment nationally,” says Stanford. “Industry profitability is down 30 per cent from 2000 levels.” With the advent of additional supply from non-traditional products such as timeshare, fractional ownership and freehold resort residential, Stanford says strong recovery will be unlikely.

Events such as 9/11 and SARS suggest the limited-service/focus-service segment weathers downturns far better than the full-service segment. “Typically, we see not only a reduction in travel, but also a downward shift in price point and product use. Many full-service hotel users move down the scale to limited-service and focused-service hotel offerings,” says Stanford. “The operating economics of full-service hotels provide additional challenges for this segment.”

Should a slowdown occur, all segments and regions will be impacted. “A lot of the industry growth in Western Canada can be attributed to the strength of the resource sector,” says Stanford. Should that sector suffer, much of improvement would be lost. “If the slowdown directly impacts the manufacturing sector, then Central Canada would feel a more significant loss.” 

Demand and occupancy recovery hasn’t been as strong in Central Canada, where ADR growth is far more modest. There, industry profitability is still 10 per cent below 2000 levels of national performance. “There is strong development interest in urban areas in Central Canada. This new supply growth has continued to temper occupancy growth, and as a result, rate and bottom-line growth.” With the exception of a few select markets, prospects for growth in Atlantic Canada remain limited, with industry profitability 30 per cent below the national average.

“There are clearly going to be challenges and opportunities, not only for owners and operators, but for the hotel companies themselves,” says Stanford. “Labour shortages and higher costs will force the industry to look at new ways to deliver and improve services without increasing — and potentially reducing — the labour requirements.” Technology will also continue to play a key role, through enhanced reservations alternatives, improved check in and check-out procedures, and in-room service. “Owners and operators will not only be looking to the brands to drive business, but also to provide solutions to the challenge of increased client expectations,” says Stanford.

According to MacDonald, there are varied opportunities for new-build hotels in many areas of the country, especially in Western Canada. She believes the extended-stay market is still underserved throughout the country. And with a total of 2,200 new hotels rooms to be added in Toronto with the completion of multiple new luxury properties, the upscale traveller will be in high demand.

Recent changes to REITs and their taxability are bound to impact the industry as well. “The new requirements REITs must meet to qualify for exemption from the proposed taxation of trusts will likely lead to restructuring, the potential sale of assets, going-private, conversion to a public company or other alternatives,” says Rosen, who believes we may see a significant number of hotels or portfolios of hotels put up for sale. “It could become a buyer’s market, which will impact valuation — pricing will likely come down.”

According to Michael Smith, real estate and hospitality analyst, Equity Research, National Bank Financial, “2007 should be an interesting year for REITs. Similar to other sectors in the REIT industry, we’re projecting M&A activity among the Canadian hotel REITs. In 2007, we expect one of the four major Canadians hotel REITs will be privatized.”    

If business from the U.S. doesn’t increase significantly, Canadian hoteliers will need to focus on growing their share of the domestic leisure market. “The industry has to do a better job of marketing to U.S. travellers,” says Rosen. “We need to give tourists compelling reasons to come to Canada and our cities. Don’t discount rates even if demand declines — it only makes it harder to bring them back up.” 

With 65 per cent occupancy in 2006 and an ADR of $124, national occupancy has finally recovered to 2000 levels. “Rates were 12 per cent more than the 2000 level of $111,” says Stanford, but he’s also quick to caution, “it’s still about $5, or four per cent behind inflation.”

Given strong industry fundamentals, there’s a wider range of lenders looking to finance today than even five years ago. “If you have a relatively new, branded focused-service or select hotel, or are considering development in a good primary or secondary market, there are a number of willing lenders. This includes specialized lenders such as GE Capital and Textron,” says Stanford. “In Western Canada, the trust companies and credit unions also play a strong role. Traditional banks are more active today, but they’re certainly not the most active. If you have a unique product, or are in a tertiary market, the interest in providing financing is certainly not as strong.”      

MacDonald says financing has never been more accessible in the past 10 years. Rosen agrees but adds, “It’s easier for branded limited-service and select-service hotels to get financing and more difficult for independent, boutique or full-service hotels, unless they are part of an upscale condominium project.” And, he warns, if you’re a resort property it’s almost impossible.

While there’s been a significant influx of U.S. buyers into Canada in recent years, there’s also been an influx of new domestic investors coming to the accommodation sector from the commercial sector. “Last year, the national yield on hotel transactions in the U.S. was in the range of nine to 10 per cent,” says Stanford. “The average yield in Canada was a full basis-point higher in the range of 10 to 11 per cent.”  Stanford believes there’s still an opportunity for those U.S. buyers to acquire similar assets in Canada and generate superior returns. “The same can be said of new domestic investors coming to the accommodation sector. With yields on many commercial properties in the five-to-six-per-cent range, despite its higher risks the accommodation sector has become more appealing.”

The ability of owners looking to take advantage of this interest and dispose of assets will depend on the nature and location of those assets. “Blue-chip assets in major markets will continue to be of interest to these two investor groups, and should expect to sell on yields below the national average,” says Stanford. “Secondary assets in secondary markets — while still appealing to the traditional domestic investor — will be of less interest to these groups, and as result, will not see the same downward pressure on yields.”    

As for future growth, hoteliers must keep responding to consumers’ changing demands, but given the tight labour market, whether they’ll be able to deliver remains to be seen. “The basics of good service are always in high demand,” says Rosen. “Hotels need to ensure there’s no waiting at check in, and provide high-quality facilities with up-to-date technology.” Once those needs are met, MacDonald says “hotels will be able to deliver by aggressively increasing rates when the market can bare it, and then reinvesting capital into their assets.” 



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