While some factors are easing the constraints on hotel construction, new hotel projects are facing challenges earlier in the development process.

The cost of capital to build hotels has increased significantly since the Federal Reserve began raising interest rates in March 2022. Even before the interest rate increases, lenders interested in hotel projects had stepped back to watch how the industry's recovery from the pandemic panned out.

Higher interest rates complicates financing for new projects, requiring owners to put in more equity or have enough cash flow to support those higher rates, said Jan Freitag, national director of hospitality market analytics at CoStar.

“When you are were thinking of it at a 3% or 4% environment and suddenly, you’re at an 8% or 9% environment, that matters dramatically to the developer,” he said.

For those able to pursue financing for a new hotel project, the question becomes who will lend to them, Freitag said. As STR and Tourism Economics forecast a mild recession this year, the big lenders are expected to sit out on new projects for a while. Even smaller lenders, such as regional banks, might hold off on commercial real estate that has one-night leases.

STR is CoStar’s hospitality analytics firm.

Even after approvals, developers run into construction delays, a shortage of available construction crews and limited access to fixtures, furniture and equipment, Freitag said.

One positive factor is that the slowing of multifamily and single-family housing construction frees up capacity for work crews, as well as materials, for hotel projects. That could help somewhat to speed up the construction phase.

STR forecasts new hotel supply growth in the U.S. to reach about 1.1% in 2023 and 1.3% in 2024, Freitag said.

“The forecast is basically that there’s not a sudden acceleration,” he said.

Hotels in leisure or vacation markets have performed phenomenally over the past three years while downtown, office-driven locations have lagged, Freitag said. If a developer has the option to build anywhere, they’re likely going to pick markets with strong leisure appeal.

That doesn’t mean business-centered hotels won’t work, but any hotel counting on corporate and group business will require the developer to be mindful of demand expectations, he said. Many white-collar jobs can be, and have become, remote, but there are professions, such as traveling nursing and installers, that can’t go that route, so they’ll need lodging.

With all the headwinds facing new hotel projects, the problem isn’t that developers have to reconsider their expectations for a return on investment, it’s a matter of what they’ve promised investors.

“You may very well be clear-eyed about your return, that it’s no longer mid-double digits and it’s high-single digit, but your investors are still saying, ‘Hey, I expect 15%. What can you do for me?’” Freitag said.

In some cases, the conversation may be easier if it’s about returning funds instead of tempering investor expectations, he said. While Freitag hasn’t seen that happen in the hotel space, he said other commercial real estate funds are taking that route.

Noble Investment Group made a deal with Choice Hotels International to develop nine WoodSpring Suites extended-stay hotels in Georgia and South Carolina over the next two years.

Noble has always included extended-stay hotels as part of its overall investment strategy, but it has focused predominantly on those in the upscale or upper-upscale brand segments, said Ben Brunt, chief investment officer at Noble. The chance to develop economy WoodSpring Suites hotels with Choice came along and Noble executives saw an opportunity for growth in several markets throughout the states.

“Given the dynamics and the success of [WoodSpring Suites], really we’re looking at this as more I would say midscale than economy, especially with what Choice has done with the current prototype of WoodSpring,” he said.

Peachtree Group has six active projects under construction in its pipeline, said Mitul Patel, managing principal and chief operating officer at Peachtree. Four or five of those six hotels will open in 2023 with the last coming in early spring of 2024. It also has several other development projects through joint ventures in the works, such as a TownePlace Suites in Palmdale, California, and a Hampton Inn & Suites in Maui.

It has another handful of hotels under construction through its Opportunity Zone fund with other joint-venture partners. Those include an AC Hotel by Marriott in Sacramento and a Curio Collection hotel in Paso Robles, California.

“Fortunately for us, some of these projects were priced in 2021 versus 2022,” he said. “2022 obviously got a lot worse in terms of escalation and inflation.”

Peachtree believes in its thesis and the underlying real estate, but the leading consideration is the opportunity to drive average daily rate with newer products in markets with older supply, he said.

OTO Development has both the AC Hotel Naples and the AC Hotel Jackson currently under construction in Florida, CEO Todd Turner said via email. Both are scheduled to open by the end of 2023.

While it’s a challenging environment to build, the quality of the hotel sites and the performance of the markets in 2021 and 2022 gave the company confidence in the long-term strength of the hotels’ performance, Turner said.

The WoodSpring Suites development deal will test Noble’s strategy of entering the extended-stay space lower in the chain scale, Brunt said. The brand and the segment have a proven track record, and economy and midscale extended-stay hotels performed the best at the height of the pandemic.

As new development becomes more challenging, economy and midscale extended-stay hotels become more appealing because of the long-term demand for these hotels, Brunt said. In many cases, these hotels become a type of housing for people. It adds stability to Noble’s investment strategy because it’s a dependable revenue-generating business.

“That’s due to the high occupancies that are achieved by these types of assets in the growth-oriented markets,” he said.

Patel said with each potential hotel development, he considers the underlying real estate — the location, the market itself, what competitive advantage Peachtree would have and whether it’s aligned with the right brand.

Peachtree focuses on hotels in the middle range of the chain scale, so essentially no full-service, 300-room convention center hotels and no economy hotels, he said.

Peachtree executives plan to pause for a few months on new hotel development until there’s some stability in pricing, and to assess how the market reacts to interest rates increases, he said.

Brunt said he hopes for a more-stabilized development process, similar to before the pandemic when it was possible to build a hotel in 12 months and have the furniture, fixtures and equipment ready to go.

It has become much more difficult to predict the hard cost inputs and the project schedule for both new-build and renovation projects, Turner said. Both the reduced availability and the increased cost of debt have added to the other financial feasibility challenges.

“We expect that lenders will begin reevaluating their position early in 2023, but I imagine that they will only pursue A-plus projects with a low-risk position,” he said.

Noble targets growth-oriented markets across the U.S. for new development, Brunt said. Roughly 20% of its equity goes to ground-up development. Its projects in development this year include a hotel in Savannah, Georgia, and one set to break ground in San Diego.

Hotel prognosticators expect new supply to stay down compared to industry averages, and Noble has the advantages of access to equity and debt capital, its brand relationships and its long-term commitments to developing in the right markets at the right time, he said.

“We feel like we have an advantage that will give us perhaps greater opportunity with less competition as we head into a different cycle of the broader marketplace,” he said.

Peachtree is confident about the projects it has under construction and on the path to opening, Patel said. The challenge will be getting financing on any new projects for the foreseeable future. In the meantime, the company plans to focus on its existing portfolio, pruning it and reinvesting capital.

“We've got about 25 to 30 renovation projects as well, so our goal is to make those into a new-type hotel and feel so that it can compete with any new supply that we're facing in markets where we're not building,” he said.

It helps existing hotels that there’s almost no new supply coming in, Patel said. Still, Peachtree is going to continue to move forward because of the markets it’s entering with trusted product types.

“We’ve also got lower leverage, which probably allows us to obtain that financing whereas a lot of people like to leverage the project up, so that's another different category in itself,” he said.

OTO Development is still pursuing new opportunities for development and acquisition, Turner said.

“While there are fewer viable opportunities in our windshield today given the economic challenges, we will be ready to move on any viable project that fits our model,” he said.

OTO Development prefers to invest in locations with bright futures and strong hotel performance fundamentals, Turner said. For example, the company has favored Sun Belt markets with leisure-driven demand profiles for several years.

“We want to invest in places to which people and jobs are moving, and that are relatively friendly to new investment but have some barriers against oversupply,” he said. “These factors provide some market upside direction and protection on the downside.”

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