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Is the Current Bull Run for Chicago’s Hotel Sector Nearing an End?

The hotel industry has gained momentum over the last few years, with impressive increases in revenue per available room (RevPAR) and a continuing development boom in virtually all major markets across the Midwest and the nation.

In the Chicago hotel market, RevPAR increased 7.2 percent in 2014 on a year-over-basis, according to STR Inc., and RevPAR was up 7.7 percent through the first 11 months of 2015.

With consumer demand so strong and the development pipeline quite active, it might feel like the challenges of the last recession are long in the past. The reality, however, is that in a cyclical market the next downturn is never too far away.

There are some indications that the ride may be slowing down and that the good times the region and the industry have enjoyed in recent years may be coming to an end.

Oversupply Concerns

Bob

Robert Habeeb, First Hospitality Group

While Chicago’s construction pipeline is smaller than a number of other metropolitan areas, it is the Windy City’s most robust development pipeline in recent memory. In aggregate, there will be a 20 percent increase in the room supply over three years. That could easily balloon to 25 percent with projects recently announced.  This is very likely to outpace demand in the short run.

Research firm Lodging Econometrics reports that 9,633 hotel rooms were in the construction pipeline in metro Chicago in the third quarter of 2015. That figure includes hotel rooms currently under construction, plus construction starts scheduled within the next 12 months and projects in the early planning stages.

Chicago’s hotel construction pipeline represented 8.7 percent of existing supply in the third quarter of 2015. In other cities, the development pipeline is even more ambitious. The construction pipeline in the New York market during the third quarter of 2015 represented 30.1 percent of existing supply. Not far behind were Miami at 25.3 percent and Seattle at 22.5 percent of existing supply.

Lodging Econometrics forecasts that 12 new hotels, totaling 1,803 rooms, will open in metro Chicago in 2016 for a growth rate of 1.6 percent. By comparison, 55 hotels totaling 8,174 rooms are projected to open in the New York market in 2016 for a growth rate of 7.1 percent.

Leisure Travel Booming

On the bright side, leisure demand in Chicago continues to be exceptional. That is important because with a sizable chunk of hotel product either due to open shortly or moving through various stages of the development pipeline, the city will continue to see more pressure applied to the supply and demand curve.

Perhaps the single most important factor to watch with respect to the Chicago hotel market in 2016 is whether — and to what extent — strong leisure demand will continue to offset the influx of new hotel properties.

My view, which is similar to the view of other hotel professionals who are familiar with the market, is that demand will not be able to keep up with supply. However, that imbalance may not be evident until later in the year, and a strong summer travel season may delay that tipping point.

Chicago is not the only Midwestern city where the pace of development has sparked oversupply concerns. The Milwaukee, Minneapolis and Omaha markets are seeing a similar dynamic play out. Supply has even been spiking in some smaller secondary markets like Ann Arbor, Michigan.

The question of whether supply will outpace demand is changing from “if” to “when” in many of these markets. As nontraditional brands and new concepts begin to fight for elbowroom in already crowded markets, stiffer competition and high levels of supply will invariably lead to struggles from weaker performing properties.

Other Factors At Play

While the city’s status as a premier regional, national and even international leisure destination remains secure, there are some outside factors to watch. One of those is a continuing state budget crisis in Illinois, which has prompted budget cuts that have directly impacted tourism promotion.

Recent tax hikes are also cause for concern. The Cook County Board of Commissioners recently approved another one-percentage-point tax on hotel stays in the county. Consequently, the nightly tax on a hotel room in Chicago will increase to 17.4 percent in May.

Meanwhile, a one percent increase in the sales tax rate went into effect at the start of this year in Chicago. The Cook County board raised the sales tax to 10.25 percent, one of the highest in the nation.

Rate Discounting Is Wildcard

While there is little reason to suspect that the next downturn will be anywhere near as bad as the recession of the late 2000s, the collective industry response when things do start to slow down will go a long way to determining the severity of the next slowdown.

As supply peaks and demand softens sometime in the next 12 to 24 months, we will likely begin to see occupancy numbers dip. Whether that turns out to be the beginning of a modest downturn, or a more significant negative cycle, depends largely on whether we have learned our lesson with setting rates.

If hoteliers can avoid the deep discounts and irrational rate behavior that leads to a race to the bottom in down cycles, it will go a long way to minimizing the depth and duration of any slowdown. Artificially low rates and extreme discounts may bolster occupancy, but overall performance will suffer.

The overall health of the industry should remain strong through the next downturn if hotel owners and operators can remain disciplined about rates. The structural fundamentals remain reasonably good.

While Chicago and other Midwest markets are arguably already overbuilt — and will become more so by the end of 2016 — the disparity is not so dramatic that it cannot be overcome with sound management and discipline.

Interest Rates Matter

There is another form of rate that may even be a bigger factor — interest rates. In December, the Federal Reserve Board raised the federal funds rate from near zero to a target rate between 0.25 and 0.50 percent. If more short-term rate hikes by the Fed occur and interest costs begin to spike, that could put a great deal of pressure on the industry in the midst of what would likely be a downturn.

One thing for certain is that there will be a lot to watch for and talk about with regard to the Chicago hotel market and the lodging industry as a whole in 2016.

— By Robert HabeebPresident and CEO, First Hospitality Group. This article originally appeared in the February 2016 issue of Heartland Real Estate Business magazine. 

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