Waikiki Construction Refreshes Hotels

Current construction is a partial preview of the future

(page 2 of 3)

Hidden costs

In many ways, Outrigger's nearly $1 billion Waikiki Beach Walk project is the paragon of development. It's been both a commercial and aesthetic success, converting a shabby neighborhood into vibrant and profitable mixed-use. But Carey notes that a lot of that success was lucky timing. "The good thing for us, when we were doing the Waikiki Beach Walk, is that the sun was out in the capital markets and it was shining on us. We were easily able to raise both equity capital and debt capital and get the project done. If we had started the project last year, though, we might not have been able to raise the capital at an affordable level that would enable the project to go through."

     An artist’s rendering of Kyo-ya’s proposed Diamond Head
     Tower of the Moana Surfrider, shown at right with arches
     on the top floors.
     Rendering: Kyo-ya

Carey says development in Waikiki is run through with these kinds of contingencies. "There are several things that feed into the construction of new projects," he says. "First, you have to have demand in the marketplace that says there's a need for the product. Then, the cost of the project has to be at a place where you believe you can sell it at that demand level. Finally, you have to have a cost of capital that enables you to build it at a price to serve the demand level. That's a lot of things to line up at once."

"The challenge in Hawaii," he says, "and in Waikiki in particular, is that the entitlement process is very long; so, when you start, the demand may be there for the project that you conceived of, but by the time you finish the entitlement process, it may no longer be there. Or, it may be there, but the cost of capital may be too high to meet your pro forma. That's what makes Hawaii really tough. It's a good news/bad news kind of thing. The good news is if you get all those things done, it's enormously successful. But the risk factors are very high."

Carey also notes that development in Waikiki – particularly away from the beach – is hampered by cost constraints. "If you want to build a high-rise hotel," he says, "the rule of thumb is you need to get a dollar of average-daily-rate for every $1,000 of construction costs. In Waikiki, it probably cost, at a minimum, $350,000 to $500,000 a key to build a high-rise hotel, which, using traditional underwriting, suggests you need $350 to $500 a night in average rate to make a pure hotel. There are very few locations that enable that kind of underwriting." It's this calculation, he says, that explains the paucity of new hotel projects.

     Part of Outrigger’s Beach Walk project.

If not hotels, what construction opportunities are left in Waikiki? There's retail, of course. Successes like Beach Walk and the Royal Hawaiian Center have undoubtedly inspired projects from the Waikiki Shopping Plaza expansion to the proposed redevelopment of the International Marketplace. In fact, retail is an inevitable part of the trend toward mixed use, but, as Carey points out, the realities of financing make timeshare and whole ownership condominiums especially attractive.

"This is my own opinion," Carey says. "Investors in timeshare and whole ownership condominiums do not have the same investment return criteria that a professional equity fund would have. So, the Blackstones of the world that bought Hilton, Cerberus that has Kyo-ya, Whitehouse Goldman that has pieces of hotels down the street, Deutsche Bank, etc., they all have fairly stringent return criteria. They talk of an unleveraged return in the teens and a leveraged return of as much as the twenties. That's a pretty high bar.

"In contrast," Carey says, "the average condominium owner doesn't walk into their condominium purchase and say, 'I need an internal rate of return of 25 percent.' He thinks, 'Hey, if I can cover my cash flow and real estate taxes and have a nice vacation home, wouldn't that be great!' If you calculate the equity return on that, it's 1 percent, maybe 2 percent. And the timeshare purchaser doesn't even think about return; they think about prepaying for their vacation. So, the cost of capital is lower for the developer of those kinds of projects. Trump Tower, for example, was a whole ownership condominium purchase. If the construction cost was $400 to $500 per square foot, it was sold at an average price of $1,600 per square foot. You can do the math."

     Planned shops at the Princess Kaiulani Hotel.
     Rendering: Kyo-ya

In fact, Outrigger took advantage of some of Trump's windfall. "We actually owned that site," Carey says. "We were originally planning that to be a high-rise hotel, so we went through exactly this same conversation." Ultimately, Outrigger decided the numbers didn't work for a hotel and sold the site as part of the Beach Walk project. In effect, they used the Trump project to help subsidize the rest of their mixed-use project, a strategy that takes a lot of risk out of development.

"That's why Kyo-ya is so excited about a beachfront deal," Carey says. "Their plan, I think, is to sell a bunch of the rooms in condominiums to create the equity capital that will allow them to cover the risk factor, then they can borrow the money to build the hotel part. But that only works on the beach, where you can get a high-ticket price. I don't believe, in today's world, you could get any of that kind of work done on Kuhio Avenue. I don't think you could underwrite it – to use an industry word – to get financing for a high-rise hotel on Kuhio Avenue, because the average rate potential isn't high enough to cover the cost of construction. Of course, that doesn't mean you couldn't underwrite the renovation of an existing hotel – we've made our career out of that."

Carey points out another change that has affected the viability of development in Waikiki: the rising cost of leasehold land. He notes that leases are usually based on the price of the land. "And because of the acceleration in the price of land, lease costs have escalated dramatically," he says. "That's become a much, much, much bigger portion of the cost of running and operating or developing a hotel. Historically, the notion was, it was just like a loan. The landowner was getting 4, 5, 6 percent return, basically like a loan on a land purchase. But now the rate of return is closer to 6, 7, 8 percent, and the land price has skyrocketed." Add that to the cost of capital and the unpredictability of the market and the prospects for new construction start to look pretty grim in Waikiki.

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