Hotel boom meets the credit crunch

The credit crunch has started hitting New York’s seemingly unstoppable hotel industry, and heavier blows will follow if the economy remains sluggish next year.

Even as the Federal Reserve’s half-point interest rate cut goosed the credit market in September, fears of further fallout from the summer’s tightening remained. The hotel market is crimped by the same factors affecting commercial deals across the spectrum. Thanks to the subprime mess, underwriting standards have tightened, debt has become more costly, and investors have to contribute more equity to make purchases in Manhattan, according to a Cushman & Wakefield report on the credit crunch’s impact on the city’s commercial real estate market.

This change comes as New York has racked up a strong year for hotel deals. Manhattan remains a highly coveted market, with 17 sales through the end of the third quarter. That matches the number of hotels sold last year, and with a total value of $14.5 billion, outstrips the combined deal value of the first nine months of 2006, according to Real Capital Analytics. Deals are still happening, such as the September closing of Rhode Island-based real estate developer and hotelier Procaccianti Group’s purchase of the Holiday Inn Soho for $128.6 million. The chain also bought the Tudor Hotel at the United Nations for an undisclosed sum.

Terms of hotel deals are changing, however — a shift that dealmakers expect will discourage investors who might have dabbled and return the focus to well-capitalized, long-term investors. Buyers are forced to return to banks, the lenders that have traditionally funded real estate transactions, because the commercial mortgage-backed securities market has dried up. Working with a bank discourages undercapitalized players because banks typically want 20 to 30 percent equity for a deal. That’s far above the 5 to 10 percent that was customary in the pre-crunch environment. Buyers that need to finance more than 70 to 75 percent may not be able to get the additional debt because of the credit crunch.

“Banks are the only outlets you can do business with these days,” says Henry Kallan, president of HK Hotels. “The higher equity requirements are obviously changing a lot of people’s buying because they don’t have the ability to put up funds, or don’t want to risk that type of money.”

The rapid pace of hotel development still raises the question of whether today’s tight market will result in an oversupply of new rooms. There are now 53 hotels under construction in the New York City area, with 7,897 rooms. The active pipeline for this market, including properties under construction and planned, totals 151 hotels with 14,726 rooms, according to Smith Travel Research. As of July, there were roughly 80,500 rooms in the New York area, with 63,000 in Manhattan.

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This development push comes after banner years for the industry since 2004. New York has emerged as one of the strongest hotel markets in the country, with substantial increases in both room rates and occupancy levels. Year-to-date through July, the most recent month for which figures were available, occupancy levels stood at 82 percent, up 1.5 percent from the year-earlier period, according to data from Smith Travel Research. Revenue per available room jumped a whopping 12.3 percent to $198.80 from the prior-year period.

Given the ability of hoteliers to raise rates and fill rooms, adding rooms may seem like a financial home run. It is risky, however, because the hotel industry’s fortunes typically mirror those of the overall economy. While the likelihood of a recession is still up for debate, many observers, from Mayor Bloomberg to Moody’s, are bracing for a slowdown. Moody’s expects fourth-quarter gross domestic product to grow a modest 1.7 percent and slowly increase next year. That sluggishness bodes ill for hotel room rates and occupancy levels, just as lots of new supply gears up.

“If 50 new hotels opened up right now in New York City, the hotel industry may be able to absorb it, but if we continue to see GDP growth less than 2 percent, that might be a real problem,” says Moody’s senior economist Marisa DiNatale.

The hotel industry is heading into its traditionally strong fourth quarter, so difficulties created by a soft economy and tighter credit may be muted until next year. Kallan says he expects fallout to be felt when new inventory now in the works comes online. Because of that lag, he is sanguine about the fourth quarter, expecting record rates and occupancies.

Kallan also noted that while room rates are at historic highs, they are still lower than in other capitals around the globe, including London, Paris and Prague. The weak dollar, which Moody’s expects to weaken even further next year, is another key driver of demand by international visitors, some of whom find New York hotels a bargain compared to prices in their home cities.

For now, some hotel market insiders are hopeful that foreign tourists flooding New York will help hoteliers endure any domestic economic woes.

“This is an international destination,” says Mark Gordon, head of the U.S. hospitality practice at Cushman & Wakefield Sonnenblick Goldman.