How will Shangri-La perform in a more crowded luxury market?

    Most outlooks on the hotel industry project that demand for hotel rooms will outpace supply for the next several years, principally due to higher construction costs keeping the number of new hotel rooms at a minimum.¹This factor underlies many positive projections by analysts, as a continued low supply environment should help keep occupancy and rates high. Yet do these projections take into account the unique nature of the Chicago luxury segment? For while supply is down overall, a look at the pipeline for new hotel builds in downtown Chicago shows that the luxury market may not behave in the same fashion as the rest of the industry.

     In 2000, a year considered the peak of the last lodging cycle,² the only luxury hotels operating in Chicago were the Ritz Carlton, Four Seasons, and Park Hyatt. In the years since that peak, Chicago has seen the arrival of just two other luxury properties: the Peninsula Hotel, and the recent conversion of the Le Meridien into a Conrad hotel, Hilton’s luxury brand.

    Looking forward from today, a dramatic acceleration in luxury supply seems to be taking place. Up to seven new hotels, all of them luxury, are projected to enter the market by 2010³, resulting in a 53% rise in rooms all in less than four years. What’s more, these luxury properties make up almost half of the hotels in the construction pipeline.

    The cause for all of this lopsided growth may lie in the fact that all seven of these new luxury hotels are condominium hotels. Normally, new supply is limited because most lenders will not offer construction loans when costs are so high, especially when the loan is secured by a property in the highly volatile hotel industry. Yet condominium hotels do not have this limitation; developers are able to raise so much equity through pre-sales of units that the projects literally pay for themselves.⁴ Instead of needing to secure a $100 million dollar loan before building, the developer only needs to sell a certain number of units, depending on their price. Does this mean that Shangri-La and the other new luxury hotels are boosting supply beyond what market fundamentals will support? Time will tell, but it may be advisable for investors to ask the developer for a copy of its market feasibility study. These studies are performed by qualified assessment firms (such as Hospitality Solutions LLC, or HVS International) prior to the decision to build and will better guide your decision making process than will your own, independent research. This point is made clear in Ernst & Young’s 2006 U.S. Lodging Report, which said

“Of most importance is that the development needs to make market and economic
sense as a hotel before ever being considered as a condominium-hotel.
Subsequently, evaluating the economics of a condominium-hotel development
beyond unit-pricing, such as the structuring of association fees, rental program
fees, and fair revenue and expense allocations, remain key issues for the segment.
With so many potential “land mines” surrounding the condominium-hotel segment, seeking
sound legal and advisory guidance and having adequate preparation, documentation,
and disclosure are absolutely necessary.”⁵

Notes