We Raised Our U.S. RevPAR Base Case Assumption In 2023 To Flat To Up 5% Compared To 2022

Despite our base case for a recession in 2023 amid the recent failure of several U.S. banks and heightened market volatility, we modestly raised our base case assumption for U.S. lodging RevPAR in 2023 to be flat to up 5% (from flat to down modestly previously) driven by low-single-digit percent growth in occupancy and flat to low-single-digit growth in ADR.

Occupancy assumption:   Our occupancy assumption is unchanged and is based on continued good leisure demand and recovery in business and group travel, especially in urban markets. Even though occupancy has not recovered to prepandemic levels, ending 2022 at 62.7% (approximately three percentage points below 2019), we expect low-single-digit percent growth in occupancy, barring a more severe downturn in the economy. Group bookings for some globally diversified portfolios, such as Marriott International Inc. and Hilton Worldwide Holdings Inc., fully recovered toward the end of 2022. Business transient demand has been the slowest to recover given a shift to virtual work since the onset of the COVID-19 pandemic.

ADR assumption:   We revised our ADR assumption upward partly based on the strong first quarter so far. Year-to-date through February 2023, ADR is 16% higher than 2019, on par with 16% ADR growth in the fourth quarter of 2022 compared to the fourth quarter of 2019. As a result, rate strength is holding up more than we previously assumed, and given the current trend, it would take a sustained deep decline in the second half for full-year ADR to decline. In addition, our revised ADR assumption reflects hotel operators that seem content to forgo more meaningful gains in occupancy to maintain attractive ADRs and drive hotel-level profitability. Also, hotels can raise rates every day, which can offset higher labor, utilities, property taxes, and other costs. Regarding the path of ADR over the year, we expect moderating room rate growth in the second quarter as the easy comparison to the omicron-impacted first quarter of 2022 gives way to more challenging comparisons to the spring and summer rate surge of 2022. We expect room rates could be flat or even down during some weeks in the second half of the year if leisure demand moderates and consumers more consistently comparison shop for better hotel rates amid greater economic uncertainty.

While our base case continues to assume a shallow recession at some point this year, the U.S. job market remains robust, as evidenced by still-strong employment numbers in February, and global unemployment remains low. Given the ongoing shift toward consumer spending on experiences, recovering business travel post-pandemic, and the propensity for vacationers to travel within and to the U.S., the impact from a possible recession may just slow down growth rates rather than cause the decline in revenue and profitability that typically occurs in the sector during downturns. In addition, China's reopening offers a likely tailwind for global travel and leisure spending this year, including on hotels. If the employment picture remains reasonably healthy, even if the U.S. and eurozone unemployment rates eventually rise later this year, then business travel will likely continue on its recovery trend.

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Group and business travel will drive 2023 RevPAR growth in many of the top 25 U.S. lodging markets, which will likely increase faster than the overall industry compared to 2022. Urban markets have a high concentration of full-service upper-upscale hotels that cater to convention attendees, group bookings, and business transient travelers. Additionally, a lack of inbound international travelers to the U.S., especially from the Asia-Pacific region, including China and Japan, severely impaired some markets. For example, San Francisco RevPAR remained 72% below 2019 in January 2022, held down by deeply depressed occupancy. In January 2023, it increased 175% to 23% below 2019.

We assume currently strong leisure travel demand may begin to soften in the second half of the year. Despite few signs of this so far, we believe persistently high inflation and negative adjusted wage gains will hit leisure travel demand at some point in 2023. Through January, wage gains adjusted for inflation were negative for each of the last 21 months and savings have declined since last summer. Tightened personal travel budgets could lead individuals and families to search for deals or pull back on travel spending as they prioritize nondiscretionary purchases, pressuring ADR and occupancy in some markets in the latter part of the year.

There is currently wide variation in 2023 system RevPAR growth guidance among publicly traded lodging companies, driven primarily by the geographic and price segment mix of rooms. Lower-priced select service rooms in nonurban markets recovered faster during the pandemic and are already at RevPAR levels well in excess of 2019. As a result, issuers with a focus on economy and midscale segments like Choice Hotels International Inc. and Wyndham Hotels & Resorts Inc., are at the slower end of 2023 RevPAR growth guidance. Conversely, issuers with a focus on upper-upscale and luxury full-service hotels in urban markets that have yet to fully recover like Marriott International Inc. and Hyatt Hotels Corp., are at the faster end of 2023 RevPAR growth guidance.

Finally, we expect supply growth within the U.S. to remain low for the next couple of years as higher financing costs and a run-up in construction expenses dampen new rooms under construction.

Macroeconomic Downside Risks Are Increasing But Have Yet To Materialize

The Federal Reserve's fight against inflation has increased risks to the economy, but we have yet to see a material negative impact to the recovery of the travel and lodging sector. Additionally, a continued hot jobs market remains a concern for the Fed and S&P Global economists forecast that a peak federal funds rate could remain at its exit rate for longer. We generally view the macroeconomic effects from the collapse of Silicon Valley Bank to be limited and that central banks will continue to adjust their policy rates, albeit at a more moderate pace, in order to bring down inflation. The most likely macroeconomic contagion channel is through consumer confidence, where uncertainty about the way current events might play out and their duration could dampen spending and demand. If widespread enough, the effects of reduced spending particularly in services, which has remained strong--would hamper employment growth.

We have also indicated increasing risks of a macroeconomic downside scenario caused by a slowdown in business activity, increased unemployment, and a steeper decline in consumer spending, in which we assume the occupancy recovery in the U.S. could falter and maybe even go backward later in the year. Combined with falling ADR, U.S. RevPAR could decline for the year. We see greater risk for upper-upscale and luxury hotels that have thus far been able to offset below-normal occupancy with higher ADR. Under our downside scenario we believe businesses could tighten travel budgets, and rate competition could increase as travelers search for deals and trade down to lower-priced accommodations. In addition, continued rising labor and other cost inflation hurt hotel-level profitability, and rising interest rates force some hotel owners with upcoming maturities to consider asset sales instead of a costly refinancing. This in turn could result in some lodging companies we rate increasing leverage to acquire hotels placed on the market, either drawing on revolver availability or cash balances and increasing net debt.

Outlook For Lodging Industry Profitability

Flattening ADR later in the year, combined with continued labor, property tax, and utilities cost inflation could hurt margins in 2023 at the hotel property level. Nonetheless, we do not expect hotel owners to chase marginal occupancy by lowering ADR, which we expect will support margin resiliency compared to previous lodging cycles. Despite significant cost inflation, U.S. lodging owners have significantly expanded EBITDA margins compared to pre-pandemic margins, benefiting in particular from a reduced labor force. The costs to operate a hotel and maintain adequate service quality were reduced at lower occupancy through 2021 and 2022. We expect hotel staffing to normalize in 2023, and as a result, margin compression could occur, especially if rate moderates later this year. Lodging managers and franchisors typically have well-above-average margins that exceed 50% (and sometimes 60%) net of reimbursed costs because the business model requires franchisees to cover hotel operating costs. Economy and midscale-focused franchisors exceeded pre-pandemic S&P Global Ratings-adjusted EBIDTA margin toward the end of 2021 and margins have remained resilient through 2022, as have luxury and full-service hotel managers and franchisors.

Rating Outlooks Remain Stable

Most U.S. lodging issuers have restored credit ratings to pre-pandemic levels. Over 80% of outlooks are stable with the remainder being positive. We currently have no negative outlooks. Rating activity in 2023 will likely depend on our assessment of risks related to labor and other cost inflation, potential moderation in ADR, and possible impact on margin recovery. Policy decisions that increase leverage, particularly for shareholder returns, could delay or limit upward rating actions. Leveraging mergers and acquisitions have been, and remain, a significant influence on the pace and timing of rating actions.

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