After four years of banner performance, the U.S. hotel market faces two questions: Can occupancy demand keep pace with a fat pipeline of new room supply? And will liquidity suffer, if fundamentals start to decline?

“The number of new hotels being built has ramped up over the past 12 months, and we expect to see that activity increase,” says Bjorn Hanson, head of hospitality and leisure at PricewaterhouseCoopers.

Hanson forecasts that 2007 will bring the highest number of hotel room starts in eight years. PricewaterhouseCoopers projects that the year-end room supply will increase by 103,000, or 2.3%, during 2007. The last time that annual room growth exceeded 2% was in 1999 near the end of the previous hotel boom. The effects on occupancy, however, will be slight this year, resulting in just a meager drop of 0.2% to 63.2%.

The new supply will not treat each market segment equally. Smith Travel Research forecasts that the luxury hotel and mid-scale without food and beverage segments will post growth in the average daily rate (ADR) of 7.4% and 6.5% respectively in 2007, a decline from 9.1% and 8.5% posted last year.

In April, roughly 49,000 rooms in the mid-scale without food and beverage segment were under construction, the thickest pipeline of any niche. The luxury segment, with roughly 6,000 rooms underway in April, had the fewest.

To be sure, some hotel rooms have been removed temporarily from the market through conversion activity and obsolescence. Smith Travel Research estimates that roughly 50,000 rooms were culled from the market in 2006, which represented 3% of the existing inventory. Demolitions of existing hotels could temper the rate of new supply growth at the margins, but many of these lost rooms will return to the market through redevelopment, say experts.

Market effects

Certain markets will bear the brunt of the new supply over the next few years. PKF Hospitality Research reports that hotel development through 2011 will accelerate at the fastest pace in Charlotte, Fort Worth, Houston, Nashville and Phoenix.

PKF Consulting President Mark Woodworth says the availability of hotel sites in each of these markets makes them more vulnerable to new development, softening room demand and chipping away at record hotel property values.

HVS International echoes that sentiment. HVS expects just two hotel markets to post declines in value this year, followed by just one in 2008. By 2010 and 2011, however, hotel values will decline in 31 and 32 markets respectively. The average value per room in 2011 is expected to be $121,000, down from the projected peak of $128,000 in 2009.

The upscale market segment will also see the most new development through the end of 2008. PricewaterhouseCoopers forecasts that upscale room supply will jump by 3% in 2007, followed by another 4.2% increase in 2008. The average increase for new room supply across all hotel segments will rise just 1.9%.

Mixed signals

One leading indicator of optimism is investor willingness to pour capital into individual hotels and portfolios. A host of opportunity funds and institutions gobbled up lodging portfolios during the first half of this year.

In April, Dallas-based hotel REIT Ashford Hospitality Trust, ranked No. 12 on the list of Top Hotel Owners with 15,492 rooms in its portfolio as of Dec. 31, 2006, paid $2.4 billion for a 13,460-room portfolio. A few days later, Innkeepers USA was taken private by Apollo Investment Corp. for $800 million.

Several large transactions should propel year-end sales volume into record territory. Last year, a record $35.3 billion in domestic hotel properties changed hands. According to Chicago-based investment sales firm Jones Lang LaSalle Hotels, that record volume eclipsed the 2005 sales volume of $19.6 billion.

Despite this pent-up demand to buy hotels, one hotel owner/developer believes that operations will increasingly dictate investment decisions in the future. Peter Connolly, a 35-year veteran of the hotel industry, is president of the hotel division at Chicago-based Palladian Development.

“Eventually the liquidity will follow the operating fundamentals,” he says. Connolly is currently developing the 75-story luxury hotel Mandarin Oriental Tower just one block east of Michigan Avenue in downtown Chicago. The project, which will include 162 luxury condominiums and 250 hotel rooms, will be completed in 2009. “This business is cyclical and the music will stop,” says Connolly. “But I don't expect it to stop before 2009.”