Short- and Long-term Implications of Discounting Hotel Room Rates. By Amber Cheung and Mark Brady Monday, 2nd November 2009
When it comes to profits, the benefits of rate discounting for hotels are illusory, and the negative effects are both immediate and far-reaching.
One of the most important decisions facing hotel managers in an economic drought is determining room rates optimal to maintaining occupancy levels and market share. As occupancy levels fall, rates tend to tumble even more quickly in an attempt to overtake them. In the current recession, rate reductions have occurred across nearly all U.S. markets at hotels representing the economy to mid-scale to luxury segments.
Discounting room rates may be a temporary solution to filling some otherwise empty rooms, but the short- and long-term consequences can be severe. The practice of discounting can also have a negative affect on profits: Smith Travel Research predicts that year-over-year revenue per available room (RevPAR) will decrease 17.1% by the end of 2009.1
Low room rates do not induce demand. Given a choice between two equal hotels, guests may opt for the one with a lower rate, but hoteliers will not succeed by this tactic in bringing guests to the market in the first place. For example, major demand generators, such as nearby beaches and the Marine Corps Military Base Camp Lejeune, draw demand to Jacksonville, North Carolina—not the falling room rates of area hotels.
Most hotel operators know that lowering rates will not bring demand to the market; however, they can help increase a hotel’s market share.
Despite this, hotel rates are extremely transparent, and competitors are quick to follow suit when one hotel drops its rate. The undercutting continues apace, and following the free fall, the market hasn’t grown and rates are down by double-digit percentages. In the end, hotels that engage in rampant rate cutting suffer from even lower profit margins and returns.
To illustrate the effects of lowering rates to fill rooms, we’ve provided the following snapshots of typical profit and loss statements for economy, mid-scale, and upscale hotels. The parameters set are for a typical hotel of each type, based on select actual operating histories in 2008.2
Economy Hotels: Assume a 50-room economy hotel commands an average rate of $60 and achieves 55% occupancy. At a typical, well-managed hotel, this would yield a house profit (before fixed expenses) of 37%.
Given the same expenses as a percentage of sales, suppose the rates are reduced to $55 to maintain 55% occupancy; house profits are thereby reduced to 34%, equating to a loss of approximately $2 per occupied room, or $34,000 per year.
By contrast, suppose rates were raised to $65 and occupancy dropped to 49%: profit margins increase to 39%.
Effect of Rate Discounting at an Economy Hotel
Mid-Scale Hotels: Assume a 100-room mid-scale hotel commands an average rate of $115 and achieves 55% occupancy. At a typical, well-managed hotel, this would yield a house profit (before fixed expenses) of 42%.
Given the same expenses as a percentage of sales, suppose the rates are reduced to $105 to maintain 55% occupancy; this move reduces house profits to 39%, equating to a loss of approximately $6.75 per occupied room, or $135,000 per year.
By contrast, suppose rates were raised to $125 and occupancy dropped to 49%: profits margins increase to 43%.
Effect of Rate Discounting at a Mid-Scale Hotel
Upscale Hotels: Assume a 300-room upscale hotel commands an average rate of $165 and achieves 71% occupancy. At a typical, well-managed hotel, this would yield a house profit (before fixed expenses) of 30%.
Given the same expenses as a percentage of sales, suppose the rates are reduced to $140 to maintain 71% occupancy; house profits are reduced to 25%, equating to a loss of approximately $16.50 per occupied room, or $1.2 million per year.
By contrast, suppose rates were raised to $180 and occupancy dropped to 59%: profits margins increase to 32%.
Effect of Rate Discounting at a Upscale Hotel
It’s a bit harder to demonstrate the business implications of chronic rate reductions in the long term, but these can have the most detrimental effects on the hotel. U.S. Hotel Trends: Yesterday, Today, and Tomorrow, a study developed by HVS, shows that the recession we are facing today is most comparable to the recession in 1980.
Unlike the 2001 recession, hoteliers are now faced with prolonged demand declines and a longer recovery period; HVS studies anticipate that growth of both demand and average rates will not resume until 2011.
However, RevPAR is not expected to return to 2007 (pre-recession) levels until 2013. This recovery period can have a severe effect on hotel performance and sustainability, and discounting rates contributes to its prolongation.
Hotel managers must also consider potential revenue loss during the recovery due to discounting, as the lost revenues compounded year-to-year are likely to have a pronounced negative effect on overall hotel performance.
Discounting rates, even as a stop-gap measure against demand loss in the current economy, can yield negative effects for hotels and the overall market. Nobody wins in the aftermath of a price war.
Discounting rates in order to increase occupancy will induce higher costs on a per-room basis and decrease profit margins. Perhaps the most deleterious effects lie in the long term, and these effects may not warrant consideration as hoteliers struggle with the immediate challenges of their day-to-day operations.
A better solution to discounting is to offer additional value to the customer without sacrificing rates. Such value additions include Internet service (which can cost up to $15 per night), breakfast or all-day coffee service, or a complimentary spa treatment during a weekend stay.
The take-away message is that rate integrity is essential to the profitability of a hotel operation in the short and long term, and it may not be too late for hoteliers to stop the rate hemorrhaging and put their properties in a stronger position to capitalize on an economic recovery.
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