By Catherine DeBono Holmes and Bruce Baltin
This article was first published in the Winter 2015 edition of EB5 Investors magazine.
For EB-5 financing of hotel projects, proving that new jobs will be created requires evidence that there is a market demand for an additional hotel in the local market. The basic requirement for any EB-5 financing is to show that a project will create at least 10 new jobs per EB-5 investor. For new hotel projects that use EB-5 financing, it is necessary to show that the new hotel is not merely taking jobs from existing hotels in the area, but actually creating new jobs. That requires evidence that there is enough guest demand in a local market to allow a new hotel to open without causing existing hotels in the area to lose occupancy. If the project owner can demonstrate that the demand for hotel rooms already exists, it can show that opening a new hotel will create new jobs, without taking away the jobs of the existing hotels in the area. How can a project owner demonstrate that this demand for new hotel rooms exists?
Hotel valuation experts have developed a method to determine market demand in a local market that can be used for EB-5 financing. Hotel consultants such as PKF and HVS have developed standards for determining what they consider the natural optimum average occupancy rate for each local market, which we will call the “optimum occupancy rate.” The optimum occupancy rate refers to the percentage of occupancy that will maximize the profitability of the hotel, based on the market conditions in that local market rate. If the average occupancy is 80 percent but the optimum occupancy rate is 70 percent, hotel consultants conclude that there is a demand for hotel rooms that is not being met, because more people are staying in existing hotels in the market than the rate that would allow maximum profitability for all hotels in the market. This article explains how hotel consultants set the optimum occupancy rate for each local market, and why an average occupancy rate in excess of the optimum occupancy rate indicates a demand for additional hotels.
The optimum occupancy rate for a local hotel market is determined by the mix of demand in that market. In markets where demand varies substantially based on seasonal factors, such as ski areas, there will be a wide difference between occupancy rates during the high season versus the low season. In areas where hotel demand is largely based on business travel, occupancy rates will be higher on weekdays than weekends, and the opposite will be true where demand is based on leisure travel. In areas where there is wide difference between occupancy rates during high periods and low periods, the optimum occupancy rate will typically be set at 70 percent. Where the difference between occupancy rates during high and low periods is less, the optimum occupancy rate will often be set at a higher percentage. For example, in San Francisco and Los Angeles, California, optimum occupancy rates are typically set at between 72 and 78 percent. In Houston, the optimum occupancy rate is about 70 percent. In New York City, where hotels are in high demand virtually all year, the optimum occupancy rate is about 80 percent. In Las Vegas, where gambling and other attractions seek to fill their venues with guests, the optimum occupancy rate is about 90 percent. In contrast, the average hotel occupancy rate in the United States is about 63 percent annually.
Why does the mix of demand make a difference in setting the optimum occupancy rate? Hotels will typically be most profitable during the times that they have the highest occupancy, since they can charge higher rates during those times. Therefore, one of the keys to maximizing hotel profitability is having enough rooms to serve guest demand during the peak occupancy periods. If a hotel does not have enough rooms to meet demand during the peak occupancy period, it is losing its highest revenue earning nights. When considering a local hotel market, if all of the local hotels are full during the peak occupancy periods, then the local market is effectively turning away guests for lack of rooms, and losing revenues that could be generated both in the hotel and outside the hotel at restaurants, shops and attractions. Therefore, the optimum occupancy rate is set in order to maximize the availability of rooms during the peak seasons, without running at a loss during the off-peak seasons.
How do hotels maximize revenues during peak periods, but not lose money during off-peak periods? Hotels are generally designed to break even on operating expenses at a 50 percent occupancy rate. Therefore, if a hotel can operate at a 50 percent occupancy rate during non-peak periods, and operate at a 75 to 90 percent occupancy rate during the peak periods, the hotel should be able to optimize its profitability.
How is the optimum occupancy rate established for each local market? In preparing a feasibility study for a new hotel, the hotel consultant will begin by compiling data on the existing hotel room inventory in a given market, using the industry standard data gathered by Smith Travel Research, Inc. and its international affiliate, STR Global (collectively, “STR”) to analyze the historical occupancy rates and room rates of the existing supply of hotel rooms in that market. STR provides monthly, weekly, and daily STAR benchmarking reports to more than 43,000 hotel clients, representing over 5.7 million hotel rooms worldwide. Using that data, the hotel consultant will estimate the average occupancy rate and room rates for all existing hotel rooms in a local market, or all hotel rooms in a specific market segment of that local market, over the last one, two or three years. The consultant will also evaluate the differences in occupancy rates between peak and off-peak periods and analyze the demand generators for that market. Using that the data, the consultant will determine whether there is excess demand during peak periods that could be captured with more hotel rooms, without causing excess supply during the off-peak periods.
Why is it better for a hotel to operate at the benchmark optimum average occupancy rather than a higher occupancy rate? Hotels that operate at higher than their optimum occupancy rate often find it difficult to maintain and service the hotel, because when rooms are full, they cannot be repaired and maintained in good condition. In addition, when hotel rooms are used too frequently, there is more wear and tear on furniture and soft goods such as linen and upholstery. Most importantly, when there are more hotel guests at the hotel, more employees are required to service the guests, and labor expenses increase. Labor expenses are in fact the highest percentage of all expenses of operating a hotel. Finding the right balance of revenues versus expenses is the key to maximizing profitability of hotel operations. If a hotel runs at a higher occupancy rate than the optimum occupancy rate for its local market, it usually means that the hotel could increase the rates and still maintain the optimum occupancy rate.
When hotel occupancy exceeds the optimum occupancy rate, the hotel owner should increase room rates to optimize profitability of the hotel. If a hotel runs at occupancy rates exceeding the optimum rate, the hotel owner may actually be able to earn more profit by increasing hotel rates and decreasing hotel occupancy. This is because the increase in revenues from room rates may exceed the net profit that is earned at lower room rates, after factoring in the extra costs of operating the hotel at higher occupancy rates.
If a local market has hotel occupancy rates in excess of its optimum occupancy rate, it typically means there is demand for new hotel room supply in the market. If all the hotels in a local market, or a segment of that market, are operating at above the optimum occupancy rate for that market, it usually means there are not enough hotel rooms in the market to satisfy existing demand. In this case, a hotel developer can show that there is a demand for a new hotel that justifies the project being built with EB-5 financing.
USCIS examiners and EB-5 financing providers should consider these industry standards in assessing the market demand for new hotels using EB-5 financing. If a new hotel developer has a feasibility study that shows an average hotel occupancy above the optimum occupancy rate in a given local market or market segment, that should be viewed as an indicator that there is likely demand for additional hotels in that market. A feasibility analysis should be done to determine whether there is excess demand during the peak occupancy periods that could be captured with a new hotel development. USCIS and EB-5 financing sponsors should look for these benchmarks in reviewing feasibility studies for new hotel developments. These are the hotel industry accepted standards used by hotel developers, investors and lenders for determining when a hotel is economically feasible, and the same standards should be applied by USCIS and EB-5 financing sponsors for hotel developments using EB-5 financing.
Contributing author Bruce Baltin is Senior Vice President at PKF Consulting USA in Los Angeles. Mr. Baltin has a wide diversity of experience in the hospitality and tourism industries including market demand studies, valuations, economic and operational consulting and dealing with leases, franchises and management contracts. Contact Bruce Baltin at email@example.com or 213.861.3309.
Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.