From Foreclosures to Cash Cows

A New Look at Hotel Profitability

By Jeffrey H. Walker, MAI, CHME

As we enter 2001, the industry seems to be settling into a state best described as cautious optimism. It is certainly true that negative factors exist: continued fears of overbuilding, Federal Reserve capital tightening in 2000, slowly increasing capitalization rates, and talk of economic slowdown, or even recession. But with continuing strong increases in hotel demand, ADR, and profitability, the industry remains strong. In fact, increased profitability has been maintained for so long that the desperate mood of the industry that dominated the early- to mid-1990’s seems to be a distant memory.

As we are riding near the top of a wave of industry success (or perhaps just beyond it), now might be an appropriate time to look at our current state of profitability, and ask that difficult question…why?

1993-1999: A Profitability Snapshot

The following chart presents key statistics for revenues and Gross Operating Profit for full-service hotels, as compiled by Smith Travel Research, for 1993 and 1999.

While recognizing that changes in sampling can skew direct comparisons, data suggests remarkable profitability changes from 1993, near the industry bottom, to last year’s figures. Led predominantly by strong increases in ADR, revenues posted dramatic gains, and GOP per available room more than doubled in the six-year period.

US Realty Consultants has analyzed hundreds of hotels, and in the process interviewed thousands of managers and owners during this period. Here are some thoughts on what led to these increases, and what ramifications might lie ahead.

Flowthrough: A Dollar Does Not Equal a Roomnight

As with any going concern with a component of both fixed and variable costs, a hotel’s increased revenues lead to disproportionate increases in hotel profits. But the latter half of the 1990’s strongly demonstrated the concept of flowthrough – or the percentage of increased revenues that flow through to NOI. Because a hotel has a high component of fixed costs, even within departmental expenses, increased accommodated demand certainly leads to increased profitability. But an extra room sold still has corresponding expenses. Conversely, an incremental dollar in ADR has limited associated expenses, limited perhaps to percentage commissions and fees. So, increases in ADR “flow through” nearly 100% to the NOI level. This helps to explain why, during a period of relatively flat occupancy, a 64.1% increase in ADR led to a 119.1% increase in profitability.

Inflation: Is It Really the CPI?

During this period of tame inflation, ADR increases have been more influential due to low expense inflation. But does the often-quoted Consumer Price Index really reflect expense trends for hotels? The Consumer Price Index was designed to reflect a typical “basket of goods and services” for household consumers.  But clearly, these typical household expenses do not reflect the expenses of a hotel. How much do they differ?

To answer the question, we analyzed the individual line items of the CPI, combined with data from the Employment Cost Index for service employees. We tracked the annual index, weighted for typical percentages of expenses at full-service hotels. We then converted the resulting weighted index, which we call the Hospitality Expense Index, to 100.0 in 1993 as a starting basis, calculating hotel-related expense growth based upon the U.S. government data. The results, compared with CPI index changes, can be found in the following table.

As demonstrated, despite low CPI inflation, expenses associated with hotels have grown at only a slightly more rapid pace, 20.3% total over the period for hotel expenses compared to a 19.3% growth in the CPI. For example, despite record low unemployment, total growth in service-related wages were held to 23.2% over the period. While still higher than the overall CPI, during this period of economic prosperity, a lack of strong wage growth has helped control overall hotel expenses. So, while ADR increases led to increased flow-through, relatively low hotel-related cost inflation allowed even more flow-through to the NOI.

Yield/Rate Management: Driving Profits or Controlling Losses?

Yield management has been a buzz-word for a decade now, but its practical implications have drastically changed since the early 1990’s. When the industry was in crisis, yield management was utilized to “put heads on beds,” making sure that rooms were not lost to rate during periods of low demand. Although these procedure have become increasingly sophisticated, we also believe the fundamental change has been increased demand in the market, leading to management emphasis on strong rates during sell-outs instead of promotional rates during weak demand.

If your hotel has seen very strong rate growth over a comparable previous period, ask yourself this question. What was the ADR growth over comparable non-sellout nights? If the growth rate percentage for non-sellout nights was significantly less than the overall ADR growth rate, then overall ADR growth has largely been a function of yield management, not underlying changes in base rates or the price/value relationship. In that case, future ADR growth may be reliant on continued supply/demand compression in the market.

Conclusions:  What Lies Ahead?

While we have experienced several years of strong demand growth and increased profits, this industry is not immune to future cyclical changes. But, if the lessons of the last upward cycle hold true, there are clear indicators of future hotel profitability. Warning signs for declining growth in profitability include not only slowing ADR growth, but a slowing number of sell-out dates during which rates can be maximized. On the expense front, wage inflation has historically been low, and recent record-low unemployment has done little to trigger wage inflation. However, wage inflation would disproportionately hurt hotel expenses, likely leading to a Hotel Expense Index outpacing the often-watched CPI growth. A combination of these influences could slow, or even reverse, recent profitability gains. But if the Fed-pursued economic “soft landing” is achieved, combining continued growth with low inflation, a profitability reversal could be postponed.