Finance & DevelopmentFinanceWhy Investors Should Consider Market Rotation

Why Investors Should Consider Market Rotation

Operating conditions in the top hotel markets in the United States have soared, with occupancies, room rates, and revenue per available room (RevPAR) all reaching new heights. According to data from STR Global, New York City hotel occupancies measure more than 86 percent, San Francisco RevPAR has leaped to more than 35 percent above its prior cyclical peak, and Miami and Boston have seen RevPAR gains of nearly 30 percent over their pre-recession peaks. These gains have been driven by swift recovery in room demand, which is fueled in part by strong foreign travel to the U.S. and gains in domestic individual travel. This has been reflected in pricing data from Real Capital Analytics (RCA), which show trophy market pricing stands 37.4 percent above its 2006 peak. Non-major metro pricing is up by a smaller margin of 9.1 percent. The value run-up is likely abetted by quantitative easing (QE), which has allowed trophy real estate assets to produce safe-haven yields amid low global bond yields. This has widened the gap in pricing between trophy and non-major metros from 81 percent in 2006 to 128 percent currently.

However, economic conditions are rotating in favor of smaller markets. The global economy has slowed, particularly in China and Latin America, which are major sources of tourism in U.S. gateway cities such as New York, Miami, and Washington, D.C. Moreover, a sharply stronger dollar has made the euro exchange rate plummet from 1.39 to 1.11, the British pound drop from 1.70 to 1.54, and caused massive weakening in the Canadian loonie and Japanese yen. As a result of all of these factors, spending by foreign travelers appears to have peaked in the near-term and will begin sapping overall demand in these markets.

Meanwhile, the surge in fundamentals in these markets has spurred massive development. Auction.com research projections show that from 2015-2018, New York City will see its hotel room stock expand by almost 26 percent, Washington, D.C., by 27 percent, Seattle by more than 17 percent, Miami by more than 15 percent, and Boston by more than 9 percent. This double whammy of rising supply and falling demand in these markets will weigh on occupancies and impact ADRs and RevPAR growth.

While foreign demand is falling and trophy markets are seeing development, many smaller markets are facing an opposite phenomenon. The domestic labor market is increasingly robust and wages are growing. This has resulted in continued gains in domestic consumer spending on hotels and motels. Additionally, gas prices are low and miles driven are once again growing after a nearly decade-long plateau. This has combined to create very favorable demand dynamics for secondary and tertiary hotel markets. Since hotel development has been concentrated in large markets, these markets are also adding less new supply. Austin and Nashville are notable exceptions.

Non-major hotel markets are likely in line for a higher RevPAR upside given the shift in the macroeconomic sands and lower development rates. They have seen less appreciation and are priced at a significant discount compared to their trophy market peers. These factors should be considered as hotel investors analyze their current portfolios and market exposures, and perhaps will result in some rebalancing, especially as the Federal Reserve moves forward on normalizing monetary policy and the current safe-haven yields for premium trophy market assets begins to dissipate. Additionally, the flow of foreign capital that has boosted trophy asset valuations and trophy city hotel asset valuations could soften amid increasingly difficult economic conditions abroad.

Chris Muoio is an economist with Auction.com.

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