Go with the Flow

The U.S. lodging industry recovery made great progress in 2011 with more than 70 percent of the hotels in the nation showing increases in both revenue and profits during the year. Many industry prognosticators are expecting this trend to continue the next three years. Based on PKF’s December 2012 Hotel Horizons forecast, U.S. hotels will enjoy compound annual growth (CAGR) in rooms revenue (RevPAR) of 6.5 percent through 2016. In turn, this should result in a CAGR of 6.1 percent in total hotel revenue during the same period. Given these strong projections of revenue growth, how much profit can hoteliers expect to earn in the coming years?

To understand how these increased revenues will flow to the bottom line, PKF evaluated the financial performance of hotels for the period 1978 through 2011. The information came from data published in our series of Trends in the Hotel Industry reports for that period. During our analysis, we measured the relationship between annual changes in total hotel revenue and movements in net operating income (NOI) for four different property types: full-service, limited-service, resort, and convention hotels. For this analysis, we defined NOI as income before deductions for capital reserve, rent, interest, income taxes, depreciation, and amortization.

Calculating Flow
For each property type we calculated a “flow-multiple” that measures how much an increase (or decrease) in revenue was retained as profits. Simply put, the flow-multiple is the ratio of year-to-year changes in profit to changes in revenue. It provides a thumbnail of how well properties managed expenses and maximized profits.

We discovered that the flow-multiples varied too much between recessionary periods and times of prosperity to compute the same way. Therefore, we chose to analyze these two situations separately using different flow-multiple calculation equations. For the years when hotel revenue increased we set the flow multiple equal to the profit variance divided by the revenue variance. This results, for example, in a flow multiple for full-service hotels in 2011 of 2.34 (a 14.5 percent increase in profit divided by a 6.2 percent uptick in revenue).

For the years when hotel revenue decreased we used a similar formula but calculated the number using the difference between revenue (-18.4 percent) and profit variances (-37.6 percent) and then divided this by the change in revenue (-18.4 percent), resulting in a flow multiple of 1.04 for full-service hotels in 2009.

Historical Flow
When looking at average flow-multiples by property type, it’s evident that full-service and resort hotels posted the most consistent multiples from 1978 through 2011. They also have the greatest ability to maximize profits during the prosperous periods, as shown in the chart. Conversely, during industry recessions when revenues fell, managers at these properties were best able to limit their declines in NOI.

Historically limited-service properties have achieved the highest profit margins due to reduced staffing levels and limited guest services and amenities. However, because of the austere level of operations, these hotels also have a high percentage of fixed costs, thus limiting management’s ability to cut expenses during industry recessions. Accordingly, limited-service hotels averaged a flow-multiple of negative 5.81 during years when revenues in this category declined. This is the lowest flow-multiple among all property types.

Convention hotel profits also exhibited a high degree of sensitivity to decreases in revenue. Over the entire period of analysis, the average flow-multiple for these properties was negative 3.34 during years when revenue declined. However, it should be noted that greatest levels of negative flow-multiples occurred during the 1980s. In recent years, convention hotels have been able to achieve more efficient flow-multiples during periods of both revenue growth and decline.

Future Flow
According to our Hotel Horizons forecast, hotels in the upscale, upper-upscale, and luxury chains exceeded their long-run average occupancy levels in 2011. As a result, RevPAR gains for properties in these categories are already being influenced by average daily rate (ADR) growth. As we know from previous research, RevPAR growth driven by ADR contributes to high flow-multiples. Based on this trend, and historically high flow-multiples, the profit outlook for full-service, resort, and convention hotels is extremely bright.

On the other hand, significant profit flow for limited-service hotels will be delayed by a year or two. The recovery for hotels in the upper-midscale, midscale, and economy segments has lagged the upper-tier properties. Therefore, ADR influenced RevPAR gains for these mostly limited-service properties will not occur until 2013 or 2014. Lagging ADR growth, combined with historically low flow-multiples, implies that profits for limited-service hotels will grow, albeit at a slower pace compared to the full-service properties.

Robert Mandelbaum is director of research information services and Gary McDade is a research analyst for PKF Hospitality Research LLC.