In Part 1 of his series, Lawrence Meyers and Monty Bennett discuss how to evaluate the hotel industry.


Lawrence Meyers

L:  I’d like to begin by educating investors on both the hotel business and the Ashford Hospitality Trust (NYSE: AHT) REIT operation. So, let’s start with hotels and learn how to evaluate them.

M: Hotels are really a dual type of business — they are both an operating business and they are a real estate concern. Let’s start with a pure play real estate business. When people think of real estate, they typically think of apartments or office buildings or shopping centers. The difference between the top and bottom lines on these types of assets isn’t that much.  The costs are largely fixed and relatively small  — utilities and the like. So let’s say an office building takes in a million dollars from its tenants in the form of rent, it pays its expenses, and has $700,000 left to distribute to its owners, pay debt service and for return on the equity to build their building.  Changes in the top line produce similar percentage increases on the bottom line.  For the example mentioned, a 10% ± change in the top line produces a 14% change on the bottom line.

For hotels, however, they are also much more of an operating business.  Here, the costs as a percentage of revenue are greater. A hotel may only have $200,000 left to distribute of that same million in revenues.  What this means is that there is a high degree of operating leverage, because of the larger percentage of expenses associated with an income stream as well as a relatively high proportion of fixed costs.

L:  Can you explain how operating leverage can cut both ways.

M:   Sure. Say you have a hotel with $1 million in room revenue and $800,000 in costs.  The profit is $200,000. If Revenue Per Available Room (RevPAR – a standard revenue metric for hotels) drops by 8%, that’s a drop of $80,000 in revenue.  Total revenue is now only $920,000.  Costs are largely fixed, though, at $800,000.  My profit is now only $120,000: the top line dropped by only 8%, but the bottom line dropped by 40%!  That difference is your operating leverage. In this case, it’s a 5 to 1 ratio. 

L:  But the reverse will be true in a good economic environment.  If RevPAR is up around 8%, that same hotel is pulling in that much more revenue, costs are still almost the same, so you can float most of that to the bottom line. 

M:  Correct.  Now, total leverage can be affected even more, and this is crucial to how hotels operate and how they use debt.  If you add fixed debt to your hotel business, you add even more leverage.

Let’s reexamine our example now.  I’ve still got $1 million in revenue coming in. We’ll add $100,000 in debt service. We’ll keep our operating costs at $800,000.  So my operating profit is $200,000 and net profit after debt service is $100,000.  Now if we have that 8% loss of RevPAR and after subtracting debt service and operating costs, net profit drops to only $20,000.  Wow. My owners are angry.  Their returns dropped 80% because of the operating and financial leverage together.

But the reverse is also true.  So when times are good, you want own hotels with relatively high degrees of operating and financial leverage.  In bad times, you either want to be in hotels with low operating and financial leverage, or not own them at all. 

One way, however, to offset financial leverage in the hotel industry is to employ a strategy that Ashford has used, which is to utilize floating-rate debt instead of fixed-rate debt.  The reason this tends to offset the impact of financial leverage is that there is a very high correlation between changes in RevPAR and changes in short-term rates.  When the economy (and RevPAR) struggles, the Federal Reserve Board tends to lower interest rates.  These lower rates then help offset lower hotel revenue growth due to the difficult economic times.  It’s a natural hedge.

L:  During the good times, do we see higher end hotels, like Four Seasons and Ritz-Carlton, do better?

M:  Absolutely. That’s because they have much higher degrees of operating leverage, and during those times the traveling public has more money to spend. Corporations are sending their people out to travel in style.  But in bad times, corporate travel is often the first expense to get cut.

L:  The hotel industry is driven by supply and demand, is it not?

M:  Absolutely. There are approximately 4.5 million hotel rooms in the country.  There is always new supply coming onto the market and there are data services that track that.  The net new supply each year has traditionally been 2-3% (although it important to note that supply has only grown an average of about 0.5% from 2004 to 2007).  The demand for hotel room nights grows at almost the same rate as the economy’s GDP. So if the economy is growing at 3%, and new supply is at 3%, nationwide hotel occupancy will be flat year over year. 

L:  So you can predict supply. And while you can’t predict what the economy is going to do, you can pretty much guess if you’ll be in a recession or not.  And if you aren’t , GDP will be in the 3%+ range.  Thus, you can pretty much predict demand.

M:  Yes, other than one-time events such as 9-11.  So, we can see that in the current soft economic environment, supply is expected to grow at a faster pace than demand, causing a decline in occupancy.  Even though occupancy is declining, it is still possible to see gains in revenue if your daily rates are increasing at a higher rate than occupancy is declining, which is this case now.

L:  Talk about occupancy then.

M: Historically, it’s been between 60 and 65% nationally.  If you’re over 63%-65% occupancy and you’re a corporate hotel, then you’re often full on Tuesday and Wednesday nights, but maybe not so on the weekends, and you can raise rates on those midweek guests.  If you’re a roadside hotel, your best night is Saturday.

Average occupancy right now is in the high low 60’s. REVPAR is up 1%-2%% so far this year due to increases in rate.  Despite the slowdown in demand, the increase in rate has still allowed for revenue growth.  

If you look at this Lodging Market and GDP chart, you see room demand is in orange. It was strong in the late 80’s, dropped below zero in 1991 with the first Gulf War, then climbed up around 3% for much of the 90’s, tanked at 9/11, recovered strongly over the next few years, and now stands around 0% growth.Now let’s look at room supply in green, or net new supply additions.  It was way too high in the late 80’s, dropped down to 1% in the recession of the early 90’s, built up in the mid-90’s, then began to slow down in 1998. 

Then after 9/11, all the new development almost completely stopped. The travel industry, as you know, was decimated.  Nobody wanted to build new hotels.   As I mentioned earlier, supply has been anemic in recentyears, but is expected to be a little above 2% this year and next, which ispretty consistent with long-term growth rates for the industry. There is also a good likelihood that supply will peak in 2009 and then begin to drop again due to the difficulty in acquiring hotel development financing in this current credit market crisis as well as thealways escalating costs of construction.

The black line is GDP.  As you can see, GDP growth definitely has a correlation to room demand.  Both have consistently seen growth rates decline since 2004 and if GDP growth continuesto decline (as some economists are predicting), then room demand growth will most likely do the same.Stay tuned for Part 2, where you’ll learn how Mr. Bennett’s extensive hotel management experience forms the basis for Ashford’s strategy.

Lawrence Meyers is a former journalist for the Motley Fool, and is President of PDLCapital, a private equity firm (  He currently owns shares of Ashford Hospitality Trust.  This article isonly an expression of the author’s opinion, may contain inaccuracies, and is not a solicitation to buy or sell any security.  All readers are advised to consult with a financial advisor prior to making any investment. The author may be contacted at  

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