Nothing's going up until rates go way up

Author: Lisa Allen & Mark Phillips
Date: 29/05/2008
Publication: The Australian Financial Review

Hotel room rates are not keeping pace with the cost of the construction of new hotels, Lisa Allen and Mark Phillips write.

Talk to anyone in the $85 billion tourism industry and they'll tell you the same thing. Business executives can expect to be slugged with massive hotel room rate increases in every capital city before investors head back into the sector and start building hotels again.

The Australian Hotels Association says room rates would need to double before any institutional investor would risk building a hotel anywhere in Australia. GPT, which manages a $900 million portfolio of hotels and resorts, puts it at a 30 per cent increase.

Veteran hotel analyst Dean Dransfield would expect an increase of 10 to 15 per cent over the next three years.  He argues that hotel room rate prices have not kept pace with the rest of the economy for 20 years.

"I paid $165 to stay in the Park Royal Hotel in Parramatta on my wedding night in 1988 and they will charge me less for that room today.  Whose fault is that?" Dransfield asks.  He blames the hoteliers for parlous room takings when compared with the returns for hoteliers in other international cities.

Average room rates in Moscow are $US323, Paris $US320, and Dubai $US283, according to Deloitte Hospitality.  In contrast, the average room rate in Sydney is just $US189, while the average in Melbourne is $US172. Perth and Brisbane are even worse.

GPT portfolio manager Bruce Morris says it would need something like the surplus Japanese capital that flooded the local hotel sector in the 1980s and '90s for there to be much of an increase in hotel construction in the near future.  "As construction and land costs escalate, the need for further room rate growth is [even] greater," he says.

In the battle for investor dollars, new hotels are losing to office projects, which cost less to build and have a higher end value.

The regional director of CBRE Hotels, Rob Cross, agrees that room rates must rise by between 20 and 40 per cent before significant new supply will be viable.  He says the cost of construction of a four or five-star hotel is more than the value of the end product, and the value of land for commercial use is higher than could be obtained for a hotel.

In Sydney, a new four or five-star hotel would cost between $450,000 and $500,000 a room to build, but the value would be $350,000 to $400,000 on completion.

"We looked at a B-grade commercial building [in Sydney] late last year for a potential hotel conversion, and we did some rough numbers and came up with $40 million to $45 million you could afford to pay for this particular building for a hotel conversion," he says.  "But they ended up selling it as a commercial building for over $70 million.  That in itself is fairly symptomatic of why it's difficult to justify either a hotel new build in Sydney or a hotel conversion, because the value of these sites and buildings as commercial is significantly higher than hotels."

That is in line with research by Jones Lang LaSalle, which concludes that although hotel values have increased annually by 10 per cent over the past five years, (double the rate of construction costs), the hotel value index is still 20 per cent below the building price index.  The chief executive for Asia-Pacific with Jones Lang LaSalle Hotels, David Gibson, says the hotel supply outlook is benign at best.

Even if all the 6,727 rooms under construction or proposed were built, the new room supply would increase existing stock on average by only 2.8 per cent a year until 2010.

About a third of those rooms are in Melbourne, which is expanding because of the impending opening of a new 5,000-seat convention centre, which will include a five-star Hilton hotel.

Also, Crown is building a $300 million, 658-room hotel close to the convention centre.

But only 610 new rooms are proposed or under construction in Sydney.

"Hotel values have not kept pace with the growth in construction costs," Gibson says.  The fit-out costs for a five-star hotel are 20 to 30 per cent more than for an equivalent premium office building.

The problem is most acute in the resources boom city of Perth, which recently topped a global (outside of North America) hotel occupancy survey by Deloitte with an occupancy rate of 85.1 per cent.  Six Australian cities made the top 20 in occupancy rates in that survey, but only one - Sydney - made the top 20 in revenue per available room, confirming that Australian rates still lag well behind the rest of the world.

JLL says Perth has just 486 new rooms either proposed or under construction on top of its existing supply of 5,564.  Its office vacancy rate is the lowest in the country, and new hotels cannot compete for development sites and dollars with commercial buildings.

Tourism lobby group TTF goes even further, calling for a 100 per cent increase in room rates in luxury hotels.

"If we don't see these increases, Australia will simply not get the right product development, particularly five star, which will see a shortfall for a very lucrative sector," TTF national manager  Evan Hall says.  "It is difficult to be an international city for tourists and businesses if you don't have five-star hotels on offer."

AHA chief executive Bill Healey says the situation is so dire that the national hotel body is calling for a return to the practice before the Sydney Olympics, when governments offered concessions for tourism investors.  "There were floor space ratio concessions, you got additional floors if you built a hotel compared with an office block."

The other problem Healey notes is labour costs.  "We are spending 30 to 35 per cent at a Hyatt Hotel on labour where a comparable European hotel is probably spending less than 20 per cent.  There is a diminishing return to the hotel if you throw in frequent flyers, credit card bookings, and the cost of online bookings .... what you pay does not necessarily go into the pocket of the hotelier.  In cities like Sydney or Melbourne, if you can't get $350 a night average for a luxury hotel, give me a break."

But Healey, like his contemporaries, also sheets some of the blame back at hoteliers.  "Hotel operators have been focused on maintaining high levels of occupancy.  Up until recently, they have tended to lock in long-term deals in lower-yielding areas like flight crew, wholesalers and corporate."

CBRE Hotels' Cross says the business travel sector, which is critical to the major hotel markets, has remained strong as the domestic economy has managed to avoid the full impact of the global credit crunch.  But he says average room rates in Australia are still among the lowest in the world.

"The Australian market is dominated by domestic corporate travel and there's a strong resistance from domestic corporates in Australia to pay international hotel rates.

"But in periods of no new supply coming in, that's when operators can raise the rate up and you will get to a stage where the operators' performances improve sufficiently so that someone will turn around and say we can justify a new build.  But we're not at that stage of the cycle at the moment."

Faced with these impediments, investors are turning towards incorporating new hotels in mixed-use projects to spread the risk and provide alternative revenue streams, and to satisfy local government planning requirements.

In a recent research report, CBRE said recent examples included the Raptis-Hilton project at Surfers Paradise, the Swiss Grand redevelopment at Sydney's Bondi Beach and the Bourke Junction development at Melbourne Docklands.

Cross says the Barangaroo site at East Darling Harbour in Sydney is also likely to have a hotel component in the final plans.

"If you cross asset classes it does give you a bit of a risk buffer.  You've just got to be careful how you integrate them so that one doesn't compromise the other."