BROOMFIELD, Colorado—Downturns in the lodging cycle can be difficult for hotel owners and operators alike. The inability to drive rate, reductions to demand and expense levels that do not decline proportionately with revenue foster a considerably challenging operational environment.
Hotel owners have the responsibility to make debt service payments and fulfill specifically defined debt service covenants, all of which become more burdensome to maintain in an uncertain economic climate and stage in the lodging cycle. For hotel operators, their management fee revenue streams are generally linked to both a hotel’s revenues and net operating income.
The struggle in sustaining upward rate growth, coupled with the difficulty in maintaining appropriate expense ratios and implementing profitable revenue management strategies, can be crippling for a hotel operation and management companies overall. Understanding a hotel’s cash-flow vulnerabilities is the single most important thing an owner or operator can do at this point in the cycle.
One of the more telling examples of the challenges brought on by a downturn is illustrated by examining the impact of a reduction in revenue per available room against on rooms expense. Utilizing STR HOST P&L data from 2008 and 2009, the graph below shows that U.S. RevPAR in the midscale, upscale and luxury segments dropped by 17% to 22.3% over that time period. However, over that same span, rooms expense per available room dropped only 8.7% to 11.7% across all three segments.
This epitomizes one of the main reasons why downturns can be so challenging to navigate for hotel owners and operators: the need to support expenses that decline disproportionately compared to the top-line reduction. In this instance, rooms expense per available room (as opposed to per occupied room) was analyzed because it more accurately compares the overall level of rooms expense. Given that this data represents a same-store comparison, examining the expense on a per-available-room basis demonstrates just how much of the rooms expense is comprised of fixed expenses that are not eliminated or reduced with reductions in occupancy.
Smaller line items are of similar concern to operators, and an examination of property operations and maintenance expense provides a great example of this. As illustrated in the graph below, with fewer rooms sold between 2008 and 2009, POM actually increased on a per-operating-room basis for both the midscale and upscale classes, with the luxury class experiencing just a marginal decrease. Even smaller line items like this can have a ripple effect on an operator’s GOP margin if they do not have the right plan in place to weather a downturn appropriately.
It is similarly important to zoom out and look at this from a more macro level. For this analysis, the performance of 4,720 same-store properties from 2008 to 2009 was examined. Of those properties, 94% experienced a RevPAR decline and 91% had a gross operating profit per available room decline over that time period. The charts below show the year-over-year RevPAR and GOPPAR growth of full-service and limited-service hotels, with the trend lines illustrating the relationship between RevPAR and profitability. The trend lines tell us that, in general, a 10% decline in RevPAR roughly translated into a 17.3% decline in GOPPAR for full-service hotels, and a 15.1% decline for limited-service hotels.
Further analysis can help in determining the impact that average daily rate and occupancy separately have on GOPPAR levels.
It is apparent why ADR declines would lead to reduced profit margins, as expenses are largely unchanged by lower rates. The only expenses that offer some relief from reduced rates are franchise fees, management fees and other fees tied to revenues.
Occupancy declines can lead to some reduced costs, albeit disproportionate relative to top line, and that reduction in expenses can somewhat soften the decline in profit margin.
This seems to be basis for the theory that ADR declines are worse for hoteliers than occupancy declines. However, occupancy declines also lead to reduced ancillary revenue from F&B and other departments, which is particularly impactful to full-service hotels. This begs the question: Should full-service hotels and limited-service hotels have different pricing strategies during a downturn? To examine this, a binary analysis was conducted for each full-service and limited service sets.
From the pool of full-service hotels which submitted HOST P&L data in 2008 and 2009, the 1,032 hotels which experienced year-over-year RevPAR declines ranging from 10% to 25% were segmented out. These properties were then bifurcated, and two distinct groups of hotels were formulated:
- those which instituted strategies of maintaining rate during the downturn—meaning hotels which experienced modest ADR declines ranging from 2% to 7%; and
- those which opted to sacrifice rate to maintain occupancy—meaning hotels with more significant ADR declines ranging from 16% to 21%.
The purpose of this analysis was understand how these opposing revenue management strategies impacted profitability. The charts below pertain to those properties which dropped rate to maintain occupancy.
It is evident that these properties clearly sacrificed ADR (-18% average decline year over year) in an effort to maintain occupancy, which only experienced a 2.3% drop. Consequently, this top-line strategy resulted in GOPPAR declining by an average of 30.9% over that same time period.
As a basis for comparison, the charts below demonstrate the effects of the opposite revenue management strategy—to maintain rate as best as possible, understanding that occupancy would be sacrificed as a result.
In the above bucket of hotels, rate was generally maintained year over year, decreasing by only 4.8%, and the impact to occupancy was more significant, dropping by an average of 11.4%. The key takeaway is that in comparison to the more occupancy-focused strategy, the impact to GOPPAR (-23.6%) was less severe for the full-service hotels that maintained rate. Looking at the data in this capacity supports the notion that maintaining rate is more advantageous to hoteliers.
The same analysis was then conducted for the 1,513 limited-service hotels which experienced the same 10% to 25% RevPAR decline from 2008 to 2009.
The limited-service bucket of hotels which dropped ADR to maintain occupancy experienced a 28.6% decrease in GOPPAR on average. The limited-service properties which held rate more in-line with the prior year were able to better mitigate the downward impact to the bottom line, with GOPPAR decreasing by only 22.4%. This analysis shows consistent findings between both the full-service and limited-service buckets, and supports the notion that ADR maintenance at the cost of occupancy is perhaps the more optimal strategy during a downturn.
Ultimately, regardless of reductions to occupancy and/or ADR, these adverse impacts unequivocally result in a glaring reduction in earnings before interest, taxes, depreciation and amortization, and this is where there could be significant ramifications.
Many hotel owners have loan covenants that tie directly to a property’s GOP or EBITDA. Reduced top-line revenues result in significantly diminished flow-through and less cash available for debt service, potentially putting requisite debt service coverage requirements in jeopardy.
There are significant ramifications for hotel operators as well, as base management fees are generally linked to revenues, and incentive management fees are typically earned by meeting profitability thresholds. Moreover, hotel management contracts typically have performance termination clauses that are directly linked to the bottom line. However, hotel management typically agreements will have “two-pronged” performance termination clauses, whereby one performance test is linked to the bottom line, and the other is linked to a top-line RevPAR index metric, so an operator is not unduly terminated due to an overall market/economic downturn while still performing well relative to competitors.
The impact of a lodging market down-cycle on the bottom line is undeniable: from 2008 through 2009, gross operating profit per available room declined by 25.4%, 26.4% and 36.1% for midscale, upscale and luxury properties in the U.S., respectively. It is the responsibility of owners and operators alike to determine a hotel’s optimal revenue management strategy and demand mix to maintain successful operations until the down-cycle is weathered and positive growth begins again. The lodging market is cyclical, and what goes down must come back up.
Blake Reiter is Director of Custom Forecasts at STR. Joseph Rael is the Senior Director of Financial Performance at STR. Both Reiter and Rael are part of STR’S Consulting & Analytics division.
This article represents an interpretation of data collected by STR, parent company of HNN. Please feel free to comment or contact an editor with any questions or concerns.