Hotel investors are enjoying increased business and leisure travel plus a shallow construction pipeline, a combination that's boosted occupancies across the nation. But are the seeds of another downturn being planted as developers scramble to meet occupancy demand with a flurry of new projects? PricewaterhouseCoopers projects that the number of new hotel rooms under construction will reach 120,000 this year, up from 82,100 in 2005, a whopping 46% increase.

To some lodging economists, this new supply won't become a headache until mid-2008, when many of these new rooms open. Cap rates have fallen significantly from 11.3% in December 2001 to 8.4% as of last fall, according to Jones Lang LaSalle Hotels. High demand and limited supply typically drive cap rates down, but a flood of new rooms could dilute occupancy and investor appetite to buy hotels.

“When the cap rates go down and the cranes go up, that's usually a recipe for trouble,” says Morris Lasky, CEO of Chicago-based hotel management and consulting firm Lodging Unlimited. The 30-year lodging industry veteran has encountered this situation before.

Others share Lasky's insights. Jan Freitag, vice president at Smith Travel Research based in Hendersonville, Tenn., indicates that hotel sources are voicing concerns about a supply glut. Some are even using the catchphrase “fine until 2009” to describe the next few years, says Freitag. The researcher indicates that the amount of planned development would be much larger, if it weren't for steep construction costs.

“The cost of land and materials has been so high in recent years that developers haven't built too many hotels, but many of them really want to catch this market now,” says Freitag.

The cost of plastic construction products jumped 21.8% during the 12-month period ending in February with much of that increase stemming from high oil prices. Many plastic products are oil-based. Reed Construction Data also reports that the cost of ready-mix concrete, which is used to pour the foundations of new hotels, increased 11.1% during the same period.

Even so, rising occupancies and room rates are driving a new wave of construction. The national occupancy rate increased by 290 basis points in 2005, reaching 63.1% by year's end. During the hotel market's last peak year of 2000, occupancy climbed as high as 63.3% before taking a nosedive in 2001. Revenue per available room (RevPAR) increased 8.4% in 2005. That was the largest annual RevPAR gain in 22 years, reports Smith Travel.

Investors have demonstrated an insatiable appetite for hotels. Hotel transactions totaled $21 billion in 2005, according to Jones Lang LaSalle Hotels, well above the $12.9 billion in total deals during 2004. Condo converters, who are famous for bidding up prices, acquired many of those properties.

Aside from driving down cap rates, conversion activity has also dampened the existing supply of hotels in recent years. “We did $1.7 billion in hotel transactions last year,” says Art Buser, managing director at Jones Lang LaSalle Hotels. “There was a residential converter interested in every single one of those deals, too.”

In one of the biggest deals so far this year, Strategic Hotels & Resorts Inc. bought San Francisco's Westin St. Francis hotel from an affiliate of Blackstone Group for $440 million, or roughly $440,000 per key. Blackstone, which acquired the hotel six years ago for $230 million, fetched a handsome return on the deal.

Buser of Jones Lang LaSalle Hotels believes that investor demand will remain strong over the next few years because most hotels continue to trade below replacement cost.

“If you can buy existing hotels under replacement cost, you have to wonder how building something new makes sense. It just has to be a better mousetrap, and that's not totally realistic,” says Buser, who believes that the prohibitive cost of new construction and labor will limit the amount of new projects.