Is the U.S. GDP a Reliable Tool for Hotel Business Decision Making?
By Gavin Davis Managing Principal, H-Fin Capital Advisors | August 18, 2019
Academia has placed a significant amount of attention on the relationship between changes in hotel industry lodging fundamentals such as revenue per available room (RevPAR) and changes in U.S. Gross Domestic Product (GDP). Citing from Macroeconomic Variables and Hotel Performance by Singh, Kim, Johnson, Mandelbaum (2016); collecting research and commenting that Wheaton and Rossoff (1998) analyzed the behavior of the U.S. Lodging Industry cycles from 1969 to 1995 concluding that a strong relationship exists between GDP and rooms sold.
In 1999 while working as intern for Legg, Mason, Wood, Walker Hotel REIT Equity Research, Ms. Marielle Jan de Beur, I ran a simple U.S. Hotel RevPAR(STR historical monthly data) to U.S. GDP correlation while lagging U.S. GDP by one quarter and increased the correlation coefficient (r-squared) from the low-90s as previously put forth in the hotel research cannon to high-90s.
In the intervening time, many macro-based studies using hotel industry lodging fundamentals as proxy for the broader U.S. economy have been produced In Macroeconomic Variables and Hotel Performance, the authors make several significant findings and flex ADR, RevPAR, Expense and Profit by time period (decades) to U.S. GDP, evidencing an increasing correlation alongside the growth (room count) of the U.S. industry (a suggestion to the authors as an adjustment to tighten the correlation over the entire time period)-this is a great paper and suggested read.
In our last article in Hotel Executive, "U.S. Treasury Bond Yields and Declining Restaurant Labor Personnel: Is a Recession Forthcoming? " we noted, in part, that U.S. Treasury yield curve inversions having a propensity for yield curve inversions to be: (a) "early," with significant "risk runaway" before the onset of a recession (if one arrives at all); (b) to be "inconclusive" as a sole data point in their issuance of a statistically significant number of historical false positives as recession tell-tales; and, (c) in the current environment, where U.S. and Global Sovereign Yields are affected by a confluence of new factors (it really is different this time), most prominently amongst those, the substantial and profound effect of the large-scale asset monetization of sovereign debt (and other collateral) by global central banks (e.g. U.S. Federal Reserve, European Central Bank, Bank of Japan) from quantitative easing programs, rendering historic yield curve inversions as less applicable than absent such influential factors in the bond markets.
At the same time, we provided a view into another simple metric: the monthly change in restaurant labor personnel for full-service restaurants in New York City tying it to two regularly published indices that the U.S. Federal Reserve utilizes to measure recession risk; and, evidencing early movement and sensitivity. We update our graph from that article below, and are not overly concerned as of yet regarding a U.S. recession – though in our H-Fin Capital Advisors, Inc. Weekly Newsletter (see H-Fin.com for our lowly monthly or annual subscription rates), we provide weekly 'summation' commentary on macro-currents and note global macro weaknesses.
Currently the labor market remains far too robust for the entire U.S. economy, itself impacted by slowing global demand and growth, to be derailed, ceteris paribus.
Checking in on the latest available (May 2019 as reported in June 2019) U.S. Monthly Hotel Lodging Fundamental Summary statistics as reported by Hotel News Now (HNN) from Smith Travel Research data, the U.S. hotel industry is healthy and growing, seeing year-over-year monthly increases of (1) Occupancy: +0.9% at 68.7%; (2) Average daily rate (ADR): +1.6% to US$132.4; and, (3) Revenue per available room (RevPAR): +2.5% to US$91.01. The May increase in occupancy, the highest since August 2018, ties nicely to the NYC full-service employment decelerating decline (i.e. positive trend within a negative trend) in the FRED chart above. HNN notes that, "the industry has now posted year-over-year RevPAR growth for 110 of the past 111 months. The longest overall expansion cycle in industry history lasted 112 months from December 1991 through March 2001."
As a result understanding where we are in the business cycle from a macro (national) and micro (city, lodging tract, competitive set) mostly confluent can assist property managers and owners in managing their assets and businesses, including items such as labor or materials purchases (commodity pricing for items such as lumber, concrete, steel are typically lowest during a recession). In turn, such decisions can have a material impact on each of asset profitability and Return on Investment and Equity.
We do not need (given the substantial body of academic research on the topic), nor is the forum (lacking the necessary rigor) to belabor the strong correlation between changes in U.S. Hotel RevPAR and U.S. GDP-it has already been definitively evidenced that the correlation is statistically significant. This article, rather, draws the reader's attention to: the timing of such, additional proxies to be mindful of (e.g. as the correlation to U.S. GDP is stronger when lagged; and, GDP itself is already published as a lagging economic indicator, understanding macro-economic proxies that provide statistically significant predictive value, earlier is of value).
Therefore, we take a closer look at Lumber Futures Prices via Chicago Mercantile Exchange (CME), the first exchange to offer price protection to the forest products industry with the listing of CME Random Length Lumber futures contracts, where firms engaged in producing, processing, marketing or using lumber and lumber products have been able to hedge their risk exposure via such futures contracts.
At the same time hotel asset owners (especially those of Type VI construction, though we find similar parallels to other commodities such as steel and concrete) can have a view into historic commodity pricing-as the saying goes, "buy the bones right", whether repurposing real estate, or in this parallel when purchasing commodities for ground-up construction-where proper planning has a material impact on return profile. Lumber demand, as one example, tends to shift rapidly based on interest rates and other economic conditions that affect housing starts. As a result, lumber prices react to supply and demand imbalances with frequent and often extreme changes.
In this chart for $LUMBER dating to 2006, we can plainly see the benefit of buying wood during a recession (see e.g. price level in 2009-2010 time period).
According to CME, the Random Length Lumber futures contract calls for on-track mill delivery of 110,000 board feet (plus or minus 5,000 board feet) of random length 8-foot to 20-foot nominal 2-inch x 4-inch pieces. Primarily, the deliverable species is Western Spruce- Pine-Fir, although other Western species also may be delivered: Hem-Fir, Engelmann Spruce and Lodgepole Pine. Mills must be located in the states of Oregon, Washington, Idaho, Wyoming, Montana, Nevada or California, or the Canadian provinces of British Columbia or Alberta. The acceptable grades are #1 and #2 of the structural light framing category. Wood must be kiln dried to a moisture level of 19 percent. The random length tally must conform to size percentage limits (see table 3 below).
Lumber of each length, for the most part, must be banded together, poly or paper wrapped and loaded on one 73-foot flatcar. Price terms are net, net. Interestingly for limited-service and extended-stay wood-frame prototype hotel construction bidders, purchasing lumber futures amidst the downturn while planning, zoning, permitting and other development activities are ongoing can also be done on maintenance margin. A builder who needs to acquire inventory (short the cash) and is concerned about higher prices could buy a Random Length Lumber futures contract now (go long the futures) to lock in a purchase price.
Later, when the builder purchases the lumber in the cash market, he would sell out of his futures obligation. If market prices have risen as the builder expected, the gain on the futures position can help make up for the loss from having to pay higher cash market prices.
In addition to labor management (being mindful not to be aggressive and risk materially impacting service levels) and commodity purchasing (if and as needed), accurately understanding where the U.S. macro-environment rests can assist in shifting target audiences (e.g. drive-to-market customer segment) for sales and marketing efforts as a business cycle begins to wane and consumers become naturally more price sensitive. Suggesting marketing strategies to optimize revenue during an economic slowdown or recession include bundling and value-added packages, obscuring fluctuations and urgency to compete directly on Average Daily Rate (ADR) with competitors in an effort to avoid losing market share.
Academic and market research suggests that marketing expenses should be reduced on order of magnitude ten percent and not drastically beyond such level. At the same time heavy focus should be placed on complimentary "freebies" whether small gifts or services which drives each of customer acquisition and retention. Successful sales efforts in bundling also include local tie-in promotions, the utilization of outside sales representatives and increasing "pound-the-pavement" personal contact sales and marketing efforts in an effort to also maintain and establish long-term relationship with the guest.
For properties without such efforts, forced to rely on weaker management and a heavier proportion of room sales through opaque channels ("heads-in-beds") they will suffer disproportionately more during economic downturns. Our suggestion is that, a priori, in better understanding or being advised of where the national and local economies rest in respective business cycles, as economic slow-down draws near, successful asset management and operations management strategies are anticipatory rather than reactionary.
Understanding the macro-environment and being ahead of the curve (i.e. before the data provides hard evidence of such in hindsight) in such capacity provides owners and managers the ability to most timely make important decisions that impact profitability and asset valuation.
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