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Targeting hotel markets with the highest barriers to entry and little to no competitive supply planned or under construction is one way to identify hotel assets with asymmetrical return potential. With some of the largest hotel markets in the US currently adding between 5% and 15% of existing supply to current hotel capacity1, the challenge shifts to identifying markets with the highest barriers to entry or supply constrained markets.

Constraints on new hotel supply for a market reduces the competition for guests which typically leads to higher occupancy, higher ADR and higher RevPAR growth rates. Supply constraints are derived from several sources and vary across both markets and time.

Supply constraints can be broadly defined as limitations on the ability to deliver new development. These constraints generally fall into three categories, although there is often significant overlap among the categories. The constraints can be grouped as follows:

  1.  Legal: Primarily zoning and land use regulations which restrict the location, quantity and/or pace of new development.
  2.  Geographic: Physical limitations such as waterways, steep slopes and soil conditions which limit the location and/or quantity of new development. This category may also include the impact of existing development at a scale and density that limits available sites ripe for redevelopment.
  3. Political: Local opposition to development which is not codified through local regulations but which nonetheless constrains development potential. 

In addition to the types of supply constraints listed above, economic factors may also limit development feasibility. For example, limited availability or high costs of construction lending often serve as a supply constraint, even in markets that are not typically associated with limited development opportunities. These types of constraints are generally temporary and adjust with the larger real estate market. 

The price elasticity of supply is a measurement used to calculate a market’s supply responsiveness to a change in price, i.e. Average Daily Rate (ADR). If the ratio is equal to one, there is a balance between supply and ADR, such that for every percent increase in ADR there is an equal percentage increase in new rooms.

A ratio greater than one indicates elastic supply, where the quantity supplied increases by more than the percentage change in ADR. A ratio less than one indicates a market that is inelastic (a value of zero would indicate a completely inelastic market), where the new quantity supplied does not keep up with percentage changes in ADR. A lower ratio generally indicates less elasticity, and is therefore a more supply constrained market. The ability of a market to increase supply in the face of rising demand varies across markets.

If supply cannot be added to meet additional demand, then prices (ADR, RevPAR and eventually capital vales) will rise accordingly. We believe that the dynamics of hotel supply influence hotel investment returns. Markets where supply is constrained generally tend to have higher RevPAR and value growth.

The markets with the highest supply constraints over the long term have included San Francisco and Los Angeles as illustrated below. The markets with the lowest supply constraints have included Baltimore and Dallas.

The following graph plots ADR growth against the price elasticity of supply over ten year holding periods beginning in 1997. The resulting trend line shows an inverse relationship between price elasticity of supply and ADR growth. As the price elasticity of supply ratio grows, the long term ADR growth declines. In other words, markets with a higher level of supply constraints have generated stronger ADR growth. The correlation between these variables is -0.47. About 22% of the variation in ADR growth over the ten year holding periods is explained by supply elasticity….not a small amount in anyone’s language!

Source: Hotel Investment Strategies, LLC based on STR data.

1. According to STR, six of the major US markets reported more than 5,000 rooms under construction between new construction, expansion, renovation and conversion projects. New York led with 13,801 rooms, which represented 10.9% of the market’s existing supply, followed by Las Vegas (9,259 rooms, 5.6% of existing supply).

1. New York: 13,801 rooms (10.9%)
2. Las Vegas: 9,259 rooms (5.6%)
3. Orlando: 7,322 rooms (5.7%)
4. Nashville: 6,770 rooms (14.5%)
5. Los Angeles/Long Beach: 6,111 rooms (5.8%)
6. Dallas: 5,709 (6.1%)