What’s Wrong With the US Hotel Industry Recovery?

If the US economy is in recovery, why is the US hotel industry still in rehab?

A year ago, I authored a post titled US Hotel Performance – Time for a Baseline Reset? – it was a follow-up to a post from four months earlier titled US Hotel Industry Recession Enters New Rate Erosion Phase.

In the 12-16 months since those posts were written, I am very pleased to report that hotel demand in 2010 has grown more rapidly than predicted by myself, Smith Travel Research, PricewaterhouseCoopers and Colliers PKF Hospitality Research – I love being wrong – especially among such esteemed company.

However, this better than expected uptick has resulted in considerable discussion painting a rosy picture of the US hotel industry recovery. Based on many glowing reviews citing double-digit occupancy percentage (Occ %) growth and solid increases in Revenue per Available Room (RevPAR), one can easily arrive at the conclusion that the US hotel industry recovery is in full swing and that the industry is nearly back to normal.

Unfortunately, most of these evaluations only reference US hotel industry performance relative to 2009, which was the worst year on record for hotel performance. It is not particularly beneficial to benchmark the industry against those record depressed levels, so it is much better to frame the recovery relative to hotel performance in earlier periods.

On that basis, the US Hotel Industry has recovered to somewhere near 2005/2006 business levels.

2011 will undoubtedly be a challenging year for the US hotel industry. Certainly results will exceed 2010, and be well beyond the despair of 2009, but nowhere near levels that could lead one to characterize the hospitality business as healthy.

Some Good News & Bad News

Among 2010 positives is the ratio of demand to supply growth. Smith Travel Research (STR) projects demand increasing by 7.4%, with supply up by 2.0%. As a result, room occupancy will finish the year at 57.4%, a 5.4% increase over 2009.

Before one gets too excited, please recall that in 2002, the depressed year following the 9/11 attacks, US Hotel Occupancy was 59.1%.

The bad news is that average daily room rate (ADR) increases that typically trail demand growth remain comparatively weak given the significant increase in demand. The only conclusion is that rampant rate discounting is contributing to the stimulation of demand. Despite the carnage experienced in 2009, rates will end 2010 by falling an additional 0.1% to US$97.92 on an annualized basis.

Again, to put the 2010 ADR into perspective, the US Hotel Industry ADR was $97.99 in 2006.

As you might guess, 2010’s 5.2% increase in Revenue per Available Room, while a solid step forward to $56.23 from $53.71, is not quite as impressive given a more historical frame of reference. US Hotel RevPAR was $57.52 in 2005.

So here’s the problem – Depressed RevPAR levels create a profit squeeze for US hoteliers. Colliers PKF Hospitality Research projects the average US hotel will achieve a 5.6% increase in net operating income (NOI) in 2010; good news compared with 2009, but not considering that 2009 followed a record 35.4% decline from 2008.

How Deep is This Hole?
While the US economic downturn was epitomized by the Lehman Brothers bankruptcy in September, 2008, US hotels had already been watching occupancies decline since they peaked over a year earlier in late July (week 30) of 2007. At that time, weekly US hotel occupancy was at 76.4% and RevPAR stood at $80.42.

Both of Occupancy and RevPAR gradually eroded over 126 weeks until bottoming out in the last week of 2009, with occupancy limping in at 33.8% and RevPAR at a pathetic $29.02.

The descent from the 2007 occupancy peak was due to hotels aggressively increasing room rates in response to increased demand. Room rates eventually peaked nine months following the occupancy peak at $112.36 in mid-March (week 11) 2008 – although they stayed elevated until the 3rd week of September, 2008 (week 39) at $111.25, when the global financial crisis triggered the historic industry downturn pressure thereafter. Weekly ADR bottomed out Thanksgiving week (week 48) of 2009 at $84.81.

Interestingly, even though the rate decline began 61 weeks after occupancies started to fall, average rates bottomed out four weeks earlier than occupancies. Rates transitioned from peak to bottom bottom twice as fast as occupancies.

A Bit of Perspective

To get a clearer picture of how the recent hotel industry recovery is developing, a comparison of the six months ranging from the second week of June through the first week of December was prepared for the five years 2006 to 2010. This time frame was selected due to its inclusion of traditional peak summer leisure travel, peak fall business travel and the low demand Independence Day, Labor Day and Thanksgiving holiday periods.

Occupancy

As widely reported, the highly touted 2010 occupancy gains have consistently exceeded 2009 levels throughout the year, particularly during peak demand periods. Aided by the rapid occupancy declines registered in fall 2008, 2010 occupancy is now also exceeding 2008 levels.

While the occupancy gains have been the highlight of this recovery, a sizable gap still remains to attain the levels of 2006 & 2007. With Smith Travel projecting only a 1.6% increase in 2011 occupancy, based on supply growth of less than 1%, it is unlikely the hotels will be making significant advances toward 2006/2007 occupancy levels next year.

Average Daily Rate

Hotel industry profitability hinges on lodging operators having the discipline to sustain rate increases moving forward. This should come as no surprise to anyone, but based on recent results, there is limited evidence that hotels will abandon their reliance on using discounts to fill rooms.

Room rates generally started 2010 higher than 2006 and 2009, but for the past month, have lost ground to 2006 and now only exceed 2009 levels. This is a concerning statistic as demand has increased over the past year. Despite improved performance in some major destinations, in terms of a national average, average rates have not yet begun to grow more rapidly than occupancy.

At the end of July, (week 26) when compared year-over-year, weekly average daily rates began to decline more rapidly than occupancies were declining. As occupancies turned and began to increase, average rate increases have continuously lagged occupancy increases. That trend has now continued consistently for 76 weeks.

Based on my projections, weekly YOY ADR growth should begin to exceed weekly YOY Occupancy growth beginning in March 2011. At that point, the long climb is required to regain lost ground from 2007 / 2008 peak ADR levels will begin in earnest.

Revenue Per Available Room

As RevPAR is a function of Occupancy Percentage multiplied by the Average Daily Rate, accelerated RevPAR growth in 2011 would appear to be challenging. PKF projects a comparatively lower occupancy growth rate of 2.2% in 2011. Without strong demand applying upward pressure on occupancies, it is questionable if the PKF forecast of 3.9% average rate growth can be achieved when ADR fell 0.1% on 5.7% occupancy growth in 2010.

If occupancy is not driving the forecast RevPAR increases, growth must be based on the cumulative discipline of hoteliers nationwide to change their ways and trade some occupancy for higher margins. That would be a very beneficial strategy for the industry, but relies on a highly fragmented industry to dramatically depart from the practices of the past three years.

Haves & Have Nots

Lower profit levels create a challenge for owners needing to meet debt service obligations. Fitch Research [free registration required] reports delinquencies on hotels financed through Commercial Mortgage Backed Securities (CMBS) rose to 14.27% in November – up from 14.14% in October, 2010. One in seven CMBS hotel investments is delinquent on its mortgage payments.

The mixture of discount-based demand generation, continued net operating losses and highly leveraged hotel deals is a recipe for the expansion of distressed hotel inventory. The greater the number of distressed properties, the greater the downward pressure on rates as owners fight for cash flow to fund operations while financing is renegotiated.

With considerable capital sitting waiting patiently on the sidelines in the pockets of Real Estate Investment Trusts, Private Equity and real estate operating companies, one can expect to see growth in the number of hotel transactions, typically for hotels selling at 50% to 70% of replacement cost, or groups acquiring debt with plans to foreclose if owners become delinquent. That said, trophy properties are likely to continue attracting multiple bidders, driving prices higher as the market stratifies into two groups – those seeking quality, and others seeking value.

Atlas Hospitality Group’s third-quarter Distressed California Hotel Survey revealed 529 hotels are in default or have been foreclosed on, but President Alan Reay was quoted recently by Lodging Hospitality as estimating a “shadow inventory” of 1,000 hotels operating under forbearance agreements.

Additionally, Al Calhoun, managing director of Jones Lang LaSalle Hotels’ select-service division, estimated that 70% of his company’s sales inventory is distressed in some way.

Many of these distressed properties are operating under “extend-and-pretend” lending strategies, with mortgage holders postponing repayment terms in the hope an economic rebound will improve the ability of the hotels to cover their debt service.

And how is the procrastination strategy working out? Hotel loan delinquencies exceeding 30 days are now at $9.6 billion, up a whopping 71% from $5.6 billion last year.

Even worse, a mountain of hotel debt comes due over the next 24 months; the result of financial restructurings during the recession that extended repayment terms until economic conditions improved. A cyncial insider term for this process is “extend and pretend.” While funding is beginning to become available for premier properties in primary demand destinations, there is limited evidence that performance rebounds or improved access to financing will buoy the market as a whole.

Despite these somber statistics, hotel sales transactions are beginning to occur again after taking a hiatus in 2009. Real Estate Investment Trusts have accounted for 58% of U.S. lodging acquisitions so far this year, and were predominantly all cash transactions. Debt financing for existing hotel acquisitions remains highly constrained, so private-equity firms that typically participate in leveraged transactions have remained largely on the sidelines.

OTA’s Giveth and Taketh Away

In 2008, PhoCusWright benchmarked hotel brand websites as capturing a 59% online channel share. By 2010, as the result of consumers flocking to Online Travel Agencies (OTAs), hotel brand website share had eroded to 54%.

OTAs, and Expedia in particular, have in some cases achieved a capability once believe to be mythical – the ability to direct traffic volume at will. This ability does not universally apply to all hotels across all destinations during any time frame, but top positioning in search results typically drives a significant flow of business.

HotelNewsNow quoted Expedia VP Brian Ferguson as stating 95% of hotel transactions are for hotels listed on the first page of results, with more than half of those bookings going to the first five listings. In most cases, placement in Expedia’s first five listings directly results in incremental booking volume.

How does a hotel gain top ranking in OTA search results? It is a simple two part solution –

1. Strong Consumer Benefit: OTA’s want to provide consumers with the most compelling value proposition to convert a sale. Ideally, the top property would offer:
• A high demand location
• Quality facilities and service levels
• A low retail consumer price
2. Strong OTA Benefit: OTA’s want to provide consumers with the most compelling value proposition to convert a sale. Ideally, the top property would offer:
• Last room availability
• Deepest merchant discount off retail price
• Participation in all relevant OTA travel products
• Long term & ongoing support for the OTA channel

One would normally conclude that a hotel scoring top honors in each of the above categories would find itself at the top of the list. But there is one additional dimension – any particular hotel must also be able to beat out its competitors in order to capture a top page listing.

As a result, winning top placement in OTA result pages may come down to selecting the hotel willing to endure the greatest pain to successfully shift share. For non-differentiated, poorly located, marginal properties challenged to provide a competitive product, the only available tools may be to drop consumer pricing and increase the OTA merchant discount.

One very important additional point – the smart OTAs understand these dynamics very well. Even major hotel chains with multiple properties and brands represented in a specific destination lack the data to run cross-brand and cross-destination analytics to gain deep insights into traffic, pricing and conversion statistics to optimize online hotel transactions.

Many OTAs also work closely with all major hotel chains, gaining tremendous insights into the marketing strategies being employed, and most importantly, the success of various strategies when pitted against competitive strategies. It could be argued that OTAs may have better insights into hotel industry online sales dynamics than the hoteliers themselves.

The tricky part is that like any responsible business, OTAs use this information to their own advantage – not for nefarious purposes, but to maximize their sales volume and profitability. However, given that the OTAs are in competition with hotel brand websites to attract, retain and convert online customers, this breadth and depth of market intelligence tips the scales in favor of the OTAs.

Carpe Per Diem

PhoCusWright research projects that the trend toward booking online will continue in 2011 – structurally creating further downward pressure on hotel rates.

How do OTAs drive lower hotel rates? Two words: Merchant Model.

Sorry conspiracy theorists, this does not mean OTAs want hotels to fail or operate unprofitably – they unquestionably want robust consumer demand growth with lots of satisfied customers. Nor to is the merchant model a nefarious tool to undermine hotel revenues.

Simply put, merchant model room revenues are booked by hotels on a net basis, so the wholesale rate is recorded as revenue as opposed to the retail rate before commissions are deducted for agency model bookings.

The net impact is that with a hotel agreeing to offer an OTA a net rate that floats at a 25% discount to the Best Available Rate (BAR), is reported as less revenue than an identical booking to the same consumer under the agency model.

For example, for a one night hotel booking at the Best Available Rate of $100 would reflect $100.00 in hotel room revenue to the hotel. If sold under the merchant model, with a 25% merchant discount, the hotel would record only $75.00 in hotel room revenue.

As a result, the more bookings that transact under the merchant model, the hotel average daily rate statistic gets eroded by two factors a) the average merchant discount and b) the share of bookings transacted under the merchant model.

Here’s a hypothetical example for the same hotel transacting an identical volume of business in 2008 versus 2010 under two different merchant model mixes:

Hotel Benchmark 2008

• Average Rate Paid by Consumer: $100.00
• Average Merchant Discount Percentage: 20%
• Average Merchant Model Share of Business: 15%
• Calculated Average Daily Rate: $97.00

Hotel Benchmark 2010

• Average Rate Paid by Consumer: $100.00
• Average Merchant Discount Percentage: 25%
• Average Merchant Model Share of Business: 20%
• Calculated Average Daily Rate: $95.00

With only these two changes to the discount and share percentages, the hotel’s ADR was negatively impacted by 2.06%. For hotels that have a greater share of merchant hotel business, the impact would be more pronounced.

With merchant discounts increasing because of more aggressive negotiation by the OTAs due to the economic recession and an increase in the share of business being channeled through online travel agencies, the impact to the US hotel industry average daily rate is material.

This creates two challenges for the US hotel industry. First larger retail rate increases are required for hotels to keep pace on a statistically calculated ADR basis. In the example above, the hypothetical hotel would need to raise consumer rates by 2.11% to maintain the same ADR achieved in 2008. From a competitive perspective, such a move could prove problematic.

Second, US government per diem rates are calculated based on specific destination ADR’s. For 2011, in the continental US, lodging per diems have been reduced by 5.73%. Attributed solely to the economic downturn, there has been scarce mention of the contribution of merchant rates to the ADR decline as well.

The per diem reduction applies further negative pressure on hotel rates and will impact properties with higher ratios of government business. Similar to the dilemma posed by growing merchant business, opportunities to raise rates of other market segments to compensate are eliminated in this economic environment.

The impact of these rate reductions on the hotel’s bottom line can not be ignored.

Shifty Strategies
Under most circumstances, rate reductions by a single property merely serve to shift share from a competitive property and unfortunately do not serve as a catalyst to increase market demand. For owners of distressed hotel properties, desperation to fill rooms and generate cash flow to cover debt service obligations provides strong motivation to engage in aggressive tactical pricing initiatives.

Historically, hotels evaluated pricing relative to a competitive set of properties with similar location, facilities and service standards. However, with the rise of merchant model bookings and opaque product sites in particular, competitive sets have been artificially expanded to acquire room night volume from a broader range of sources.

Take for example, Hotwire.com’s slogan, “4-star hotels at 2-star prices” – a compelling consumer value proposition. The question however, is how does this competitively position 3-star and 2-star properties?

If the participating hotels price themselves rationally, the opaque channel should offer stepped pricing tiers that appropriately align hotel star ratings with graduated pricing.

I’m not seeing many examples of that behavior. Here are two recent hotel bookings into upscale hotels that epitomize the severity of the problem.

Case A – InterContinental Chicago O’Hare
Rating: 4.5 stars | Rate: $64.00/night ($78.50 including taxes & fees)
Actually an upgrade bonus from Hotwire based on request for 3.5-star property. Hotwire was offering a 4.5-star property with identical amenities at $73.00/$88.63 inclusive, but obviously elected to convert the extremely low hotel pricing into margin for customers desiring 4.5-stars.

So why the fire sale? What would inspire hotel ownership to sell the hotel at such a deep discount? Intercontinental Chicago O’Hare is a 556 Room property that opened in September, 2008 with 53,000 square feet of meeting space, 24-hour room service and a curated art gallery. The hotel filed for bankruptcy in August 2009 with $158 million in debt.

As a point of reference, the hotel is selling on a retail basis with a BAR of $119.00 or a non-refundable advance purchase rate of $89.00. The $64 opaque rate reflects a 46% discount from BAR pricing and a 28% discount from the advance purchase rate on the hotel website.

Case B – The Hotel Minneapolis, Autograph Collection (Marriott)
Rating: 4.0 stars | Rate: $55.00/night ($69.82 including taxes & fees)
Achieved by using a 9x iterative bidding process on Priceline to undercut the Hotwire 4-star Hotwire rate by $14.00.

Both of these bookings offer vivid examples of the unfathomable rate compression occurring due to aggressive discounting by upscale properties.

The Minneapolis booking provides the perfect case study for retail and opaque channel rate compression.

2-star, 2.5-star, 3.0-star and 3.5-star hotels are all offered at an identical $79.00. A 4-star hotel commands only a $10 price premium, even at these depressed prices. While this booking was for a Friday in December, it spotlights the challenges facing two-star hotels that may be pricing correctly against their traditional competitive set, only to be price-matched by a property with a 1.5-point higher star grade.

Opaque channels frequently exhibit even greater pricing anomalies – 2-star hotels priced 23% higher than 4-star hotels or 2.5-star hotels priced 6% higher than the 3-star category. Even when the pricing increases as ratings increase, the spread sandwiches 3-star, 3.5-star and 4-star hotels within only a $4.00 range.

Just to emphasize the point that ridiculously low prices may not be sufficient for ultimate bargain hunters.

Did I jump at the chance to book the 4-star hotel on Hotwire for $69? No. Normally I would have, but since getting burnt by Hotwire when they started getting too clever for their own good with hotel ratings (Hotwire Breaks Brand Promise by Gutting Rating System,) I used Priceline to book the 4-star Hotel Minneapolis, part of Marriott’s Autograph Collection of independent hotels by bidding $55.00 ($69.82 inclusive of taxes & fees.)

How did I know how to bid $55.00 on Priceline? Simple, I used a recursive rebidding process that has enabled consumers willing to do a little math and spend a bit of time to capture the lowest possible rates. I outlined the process in a guest post for Heidi Lee’s Into The Soup blog early last year.

In this particular example, I was afforded 16 instant rebid opportunities by Priceline and it only took 9 to grab the $55 rate. The end result was a rate 38% lower than the BAR on marriott.com and 18% lower than the 4-star opaque rate on Hotwire.

The processes to bypass fences established by opaque hotel sites are another topic entirely. While these techniques do not normally alter the wholesale price paid to the hotel, they do offer consumers a way to game the system and reduce the share of booking made on hotel brand sites or retail OTA sites.

Getting the Points

Upscale lodging sectors are experiencing the most dramatic strategy changes, and they are not limited to pricing and distribution decisions. Independent hotels are affiliating with major hotel chains, and the luxury brands of those chains are now becoming eligible for frequent guest point accumulation and redemption.

Perhaps the poster child for these changes is Ritz-Carlton, which became a wholly owned subsidiary of Marriott in 2000. For the past 10 years, the temptation to participate in the Marriott Rewards frequent traveler program has been resisted, with the prevailing argument that focusing on guest experience created greater loyalty than the points programs. That changed September 15 when stays at any Marriott brand can earn points for stays at Ritz-Carlton.

Why the change? Why now? While the luxury hotel sector has seen significant volume growth on a year over year basis, it still pales in comparison to precipitous fall encountered over the previous years. Ritz-Carlton needs to build a base of occupancy while attempting to sustain its retail pricing structure. The move speaks to the revered hotel chain accepting a new business reality impacting the luxury hotel business.

Independent properties are also affiliating with major chains and frequent guest programs – Independent properties are increasing the ranks of Starwood’s Luxury Collection, Hilton’s Waldorf=Astoria group, and Marriott’s Autograph Collection.

Perhaps one promotion that would have previously been considered an impossibility is Choice Hotels, known for its economy brands, winter promotion offering up to 50% off discounts on point redemptions at Preferred Hotels Group properties.

Green With Envy

Unfortunately, hotels already offer most of their services unbundled from the room rate (for example, room service, parking, mini-bar and internet access) so they will have a difficult time following the example of their airline brethren by adding fees for services previously included in the room rate.

It is doubtful that hotels could start charging separately for housekeeping, bedding, heating or air conditioning… Most would agree that most customers are making a strong case for upscale hotels to offer the free internet access and continental breakfasts included in the price of many economy and mid-priced properties.

Again, the fragmentation of the hotel market makes it relatively easy for competitors to subvert attempts by hoteliers to introduce ancillary fees, value added services or raise prices.

One promising area for the introduction of pricing premiums might be going green. In virtually every product category, green products are able to command a price premium.

Even in this area, hoteliers face challenges. YPartnership research indicates that travelers are indeed interested in green products, but the problem is that 39% of those polled would only be willing to pay a 5% premium, with another 39% willing to pay 5-9% more to environmentally responsible suppliers. Those limited opportunities don’t translate into windfall margins for hoteliers. and going green frequently means increasing operating costs to ensure policy compliance.

One additional green challenge facing hotels is that Telepresence is a substantially greener activity when compared with travel, so corporations getting serious about going green may wind up considering curtailing all discretionary travel.

Best Wishes for a Prosperous 2011

While 2010 has shown stronger demand growth than earlier predicted, national occupancy levels are not sufficiently high to constrain inventory and drive pricing higher, 2011 should show further improvement, but rate growth is predicated on the discipline of hoteliers to resist unnecessarily deep discounting.

We can all hope that the new year will bring thoughtful, strategic hotel pricing decisions, but there should be no expectations that the hospitality industry profit unicorn will be pooping rainbow cupcakes for hotel operators, owners or investors in 2011.

Of course, because of the impact of merchant hotel rates, maybe the industry is doing better than observers may be led to believe from the statistics, so there may be a glint of a silver lining around all those dark clouds.