Times and market factors change, and so do investment strategies. The Witness Group is shifting its own strategy to adapt to new changes in the economy and market factors that impact our business model.
The past seven years have provided tremendous opportunity to develop new hotels due to a low interest rate environment and normalized RevPAR levels post recession, but the paradigm is starting to shift due to a combination of interest rates trending higher and construction costs rising.
Interest rates have increased 35-50 basis points in 2018 already, with more planned rate hikes before the end of the year. Construction costs are expected to continue to rise due to demand for labor from all of the new construction activity both inside and outside of the hospitality industry, potential new tariffs on certain raw materials, and natural disasters both boosting demand and constraining raw material supply.
As a result, the rise in cost of debt combined with construction costs have squeezed return margins as the hotel market has stabilized and there is moderate to low growth in occupancy and rate in most stable markets. More importantly, there is new supply coming online every quarter that was under construction for the past several years due to the tremendous growth in RevPAR the industry has experienced over the past decade.
From start to finish, the process of acquiring land, getting approval from municipalities, and physical construction of the hotel can take a minimum of two years, during which there is no immediate return on capital. As a result, the downward pressure on returns from rising costs and the lack of return for the first several years is shifting our strategy to focus on value-add acquisitions where there is an upside through operational efficiency or a franchise transition that also provides immediate cash flow and return.
In the past two years, TWG has had as many as six construction projects going on simultaneously, which highlights the fervor for new development. Moving forward, the company’s new development strategy will be more focused on high barrier to entry markets with strong RevPAR outlooks. To supplement this slowdown in new development, they will shift focus to add 1-2 value-add acquisitions annually to sustain growth objectives.
In this environment when the hotel industry is performing at record levels and costs are rising, striking the right strategic balance between new development and acquisitions is not an easy task as the margin for error is narrow. The Witness Group is in a unique competitive advantage due to their three distinct solutions: Investment, Construction and Management.
Sagar Patel, Chief Investment Officer of The Witness Group, says, "The Witness Group differentiates itself by creating value across all three of its core solutions. As a result, we can look at a multitude of opportunities that others may pass on due to our ability to pull multiple value levers to enhance return on investment."
The combination of these three value drivers enables The Witness Group to look at and execute deals that may not be financially appealing or feasible to every investor, developer or manager.
According to Aakash Patel, Chief Development Officer at The Witness Group, “In today’s environment, we can’t simply grow by having all of our investor capital tied up in new development. While buying stabilized assets performing at peak market RevPAR can help us quickly enhance the portfolio, it doesn’t necessarily allow us to add value or find arbitrage. We are laser focused on creating value that leverages our investment, construction, and/or management solutions. That can mean we are completing a PIP, extending an expiring franchise license, or repositioning an asset--while it isn’t always the most straightforward, we are confident it allows us to enhance overall deal value.”
Due to The Witness Group’s ability to execute each component of the value chain internally, they are able to optimize performance and better manage risk on some of these complex deals that allow us to deliver on our return expectations.