U.S. hotels were able to turn a healthy 8.8 percent rise in total revenue into an impressive 15.5 percent increase in profits according to the recently released 2006 edition of Trends in the Hotel Industry published by PKF Hospitality Research (PKF-HR), an affiliate of PKF Consulting. This marks the second consecutive year of double-digit profit growth for U.S. hotels. However, expenses continue to escalate at a level more than twice the rate of inflation, causing concern for hotel owners and operators.

“Overall, the strong economy has been a blessing for U.S. hotel managers. However, it also presents some operational challenges,” said R. Mark Woodworth, president of Atlanta-based PKF-HR. “Hotels have been the beneficiaries of strong increases in demand that have resulted in tremendous gains in revenue. However, the inflated costs of such expenses as property taxes, utilities, and labor have inhibited the flow-through of top-line dollars into bottom-line profits.”

In 2005, the cost of operating a U.S. hotel grew 6.5 percent. Leading all expenses in percentage growth were utilities that grew 13.6 percent from 2004 to 2005. The largest cost center, labor and related expenses, increased by 5.1 percent last year, creating another drag on profit growth. “Hotel managers have some degree of control over expenses like labor, but limited control over contractual or municipal costs such as management fees, franchise fees, property taxes, insurance, and utilities,” Woodworth noted.

The 2006 Trends in the Hotel Industry report marks the 70th annual review of U.S. hotel operations conducted by PKF. This year’s sample draws upon year-end 2005 financial statements received from approximately 5,000 hotels across the country. Profits are defined as income after management fees, property taxes, and insurance, but before capital reserves, debt service, rent, income taxes, depreciation, and amortization

More Properties Benefit

Unlike 2004, a wider variety of properties started to benefit from the industry upswing during 2005, the second year of recovery from the 2001-2003 recession. “In 2004, we observed that the larger hotels with higher room rates experienced the greatest increases in profitability,” Woodworth said. “In 2005, all five property types in our Trends survey achieved strong gains in total revenue, as well as double-digit increases in bottom-line profits.” PKF-HR breaks down their survey sample into five property categories: full-service, limited-service, convention, all-suite, and resort.

Among the different property categories, limited-service hotels achieved the greatest increase in revenue (10.3%), while full-service hotels achieved the greatest increase in profitability (19.3%). While convention hotels lagged the other property types somewhat in terms of revenue and profit growth, the 7.8 percent gain in revenues and 12.2 percent increase in profits posted by these hotels are well above the long-term averages for this segment.

Components Of Revenue Growth

For the hotels in PKF’s 2005 Trends sample, a 2.9 percent increase in occupancy combined with a 7.4 percent increase in ADR to generate a 10.4 percent increase in RevPAR. This favorable mix of RevPAR drivers was the primary reason for the high growth in profits achieved in 2005. “Following typical market recovery scenarios, we expect ADR growth to dominate RevPAR increases in the next few years,” Woodworth noted. “In fact, the Spring 2006 Hotel Outlook forecast prepared by PKF Hospitality Research and Torto Wheaton Research calls for ADR to grow 4.7 percent in 2006, while occupancy growth slows to 1.5 percent.”

In 2005, revenues from all other minor-operated departments did not keep pace with the significant rise in rooms revenue. The combined revenues from the food department, beverage department, telecommunications, other operated departments, and rentals and other income increased by 5.6 percent from 2004 to 2005. “Since guest count is frequently the impetus of sales for these supplemental operated departments, this comparatively slow growth rate can be attributed to the fact that the number of rooms occupied grew only 2.9 percent in 2005,” Woodworth said. “Fortunately, the cost of operating these other departments grew just 4.3 percent, thus revealing that the minor-operated departments did contribute to the increase in overall hotel profitability.”

Not contributing to the increase in bottom-line profits was the telecommunications department. Sales in this department dropped another 7.6 percent in 2005, the fifth consecutive year of revenue declines.

Expenses Grow With Business Volume Total operating expenses for the hotels in the Trends sample grew 6.5 percent in 2005, double the 3.3 percent rate of inflation for the year. “As we have seen in the past, strong growth in revenues was able to mask significant increases in the cost of operating a hotel,” Woodworth noted.

At 44.6 percent of all operating expenses, labor and related costs continue to represent the largest expense item for hotels. Therefore, the 5.1 percent increase in labor and related costs incurred during 2005 contributed significantly to the 6.5 percent increase total hotel operating costs. “For the second year in a row, it was the rise in employee benefits that overshadowed the increase in salaries and wages. In 2005, the salaries and wages paid directly to hotel employees went up 4.6 percent, while employee benefits rose 6.4 percent,” noted Robert Mandelbaum, director of research information services for PKF-HR.

Rooms Department Costs | In 2005, rooms department expenses increased 7.3 percent, the single largest increase for any revenue-generating department. “Most of the rooms department expenses are variable in nature; therefore, a portion of the rise in departmental costs can be attributed to the increase in business volume (more rooms occupied and more guests). However, amenity creep (free wi-fi, enhanced bathroom products, in-room guest service technology, upgraded bedding, etc…) has once again surfaced, which impacts the day-to-day operating expenses of the rooms department,” Woodworth noted.

Fees | Two of the most significant cost increases in 2005 have been in management fees (8.9 percent) and franchise fees (9.8 percent). This makes sense since a large portion of these costs is often charged as a percentage of revenue. Analysis of these cost categories reveals some interesting results.

In the past few years, royalty fees and marketing assessments have gone up and down in sync with annual changes in rooms revenue. However, not moving in-step with revenue have been the charges for guest loyalty programs. “We are seeing an increasing number of hotels reporting guest loyalty program charges as a separate and distinct expense item as this cost becomes more significant. While hotels appear to be benefiting from the increased use of loyalty program privileges, this rise in activity does come at a cost,” Woodworth observed.

In 2005, the management fees (base and incentive) paid by the hotels in PKF’s Trends sample increased by 8.9 percent. This compares to an increase in total revenue of 8.8 percent. With total management fees growing at a greater pace than total revenue, it must be assumed that several management companies were able to earn their incentive management fees in 2005. In fact, 40 percent of the hotels reporting an incentive management fee in 2005 did not report one in 2004.

Utility Costs | With newspaper headlines trumpeting the daily increases in crude oil prices, hotel owners and operators are extremely concerned about the direct and indirect impacts of rising energy prices. In 2005, hotel utility costs rose 13.6 percent, the single largest increase of any individual expense item on a hotel’s financial statement. “The good news is that this increase, while shocking, is still less than the 27 percent growth rates observed during the energy crisis of the 1970s. The bad news is that our clients are reporting 20 percent increases in their first quarter 2006 utility bills,” Woodworth noted.

Property Taxes | It appears that municipalities all across the nation have taken notice of the rise in hotel industry profits and values. In 2005, hotel property taxes rose 6.2 percent, the largest increase since 1987. “We believe two factors have caused a rise in the assessed value of hotel properties, the basis for property taxes,” said Scott Smith MAI, a PKF Consulting vice president in Atlanta that specializes in hotel valuation. “First, industry profits have increased at a double-digit pace for two consecutive years. Secondly, the value of hotels being transacted has grown significantly since 2003, and the sale of a hotel frequently triggers a re-assessment.”

Insurance | Despite the devastation caused by hurricanes in 2004 and 2005, hotel insurance costs appear to have stabilized. On average, the hotels in the Trends sample paid 3.8 percent more for property and general liability insurance in 2005 than they did in 2004. This follows a period (1999 – 2003) when insurance costs doubled. While changes in the amount of benefits paid does affect the cost of premiums charged to hotels, so does the health of the national economy. With the overall economy growing like it has the past two years, the value of the investments made by insurance companies has risen, thus mitigating the pressure to raise premiums.
Approaching Peak Performance

Looking to the future, PKF Hospitality Research finds the U.S. hotel industry starting to approach the peak of the current cycle. Growth is forecast to continue in all major industry measurements – occupancy, ADR, RevPAR, and profits. However, the pace of growth is expected to slow down as most markets begin to exceed their long-term natural performance levels.

“Like other forms of real estate, the lodging industry performs in cyclical patterns. Based on our analysis of supply, demand, and economic conditions, we believe the U.S. hotel industry is leaving the recovery phase of the current cycle and approaching the peak,” Woodworth noted. “Life at the peak of a business cycle is both exhilarating and treacherous. While we foresee an extended period of peak performance for U.S. hotels, we also know that a potential downturn lies somewhere on the horizon.”

“Leaving the recovery phase and approaching the peak means that we will see a slowdown in the rate of revenue and profit growth compared to recent years,” Woodworth said. “However, this deceleration does not mean that the lodging industry is entering a recession. In fact, several factors lead us to forecast a persistent period of strong performance for U.S. hotels in the next few years.”

PKF Hospitality Research is forecasting total revenue growth of 7.6 percent in 2006 and 4.1 percent in 2007. This is projected to result in profit gains of 14.9 percent and 7.0 percent, respectively, in 2006 and 2007. Based on this forecast, U.S. hotels will be achieving a profit of approximately $14,800 per-available-room in 2006 and $15,800 in 2007. The 2007 figure is slightly more than the $15,674 profit level generated at the peak of the last cycle in 2000.

“On the surface, the hotel profit picture appears to be very attractive. However, in real dollars, most owners and operators are still 20 percent behind where they were in 2000. For those property owners that have been riding the ups and downs of the lodging cycle since the year 2000, their smile will not totally return until real profits have fully recovered, which might not be until the end of this decade,” Woodworth concluded.