Appealing Business Models Help Hotels Book Strong Profits
By Matt Wilson
Capital Group Equity Analyst
The first priority when scheduling any vacation or business trip is to avoid unpleasant surprises — no scheduling conflicts, jumbled reservations or misplaced passports. This maxim is especially true when it comes to lodging. Being stranded in a hotel that looks appealing online but is a letdown in reality is the travel equivalent of a bad blind date. That’s a big reason many travelers choose to stay at leading hotel chains rather than smaller independents. Even if the brand name carries a slightly higher price, the dependability and peace of mind are worth it.
Such customer allegiance is one of many features that make hotels alluring from an investment standpoint. Among other advantages, leading chains tend to boast high profit margins, modest capital needs and ample room for expansion, both within the U.S. and overseas. A hallmark of the hotel business is that growth tends to feed more growth: The greater number of locations a chain offers — from mid-priced business hotels to luxe destinations with spas and golf courses — the likelier travelers are to stay there. That’s particularly true if customers can accumulate or cash in points in popular loyalty programs.
Certainly, the lodging industry faces some headwinds. Its fortunes are somewhat tied to the economy, which is providing a lift at the moment but could pose a challengeif the cycle turns. Also, apartment-rental websites such as Airbnb are sapping some demand that would otherwise flow to traditional hotels. Nevertheless, I believe the overall outlook is extremely bright. Leading chains have impressive name recognition and enviable business models that position them well for the future.
Hotels are consumer franchises in disguise.
At first glance, hotels might seem to be real estate enterprises. In reality, however, leading chains don’t acquire real estate or construct buildings. Often, in fact, they don’t even manage the properties bearing their names. Instead, these chains are consumer brands with franchise-oriented business models.
Here’s how it works: Other entities — typically, mom-and-pop owners, investment groups or specialized real estate funds — control the land and buildings. These property owners pay a franchise fee to affiliate with a hotel chain, usually about 5% of annual revenue. As in other industries, property owners expect the imprimatur of the brand name to lure customers more successfully than they could on their own.
This structure benefits big hotel chains in several ways. It frees them of the risks and costs of property acquisition and development, while minimizing the need for capital. The chains pass along most operating expenses to the property owners, including those for marketing, website maintenance and reservation systems. In another quirk of the industry, big chains manage fewer than half of the hotels in their networks because it’s often cheaper to outsource daily operations to third parties, especially for smaller locations. For the portion of hotels that the chains do manage — generally, flagship venues in choice cities — they earn additional fees.
Reward programs are a staple of the business.
Hotels benefit significantly from loyalty programs, which dole out room upgrades and other perks to repeat customers. Much like airline frequent flyer miles, the lure of reward points provides a strong incentive for travelers to stick with specific chains. Many people diligently accumulate points at midpriced hotels on business trips in order to redeem them at higher-end venues on vacation. Customer allegiance is critical to hotel chains, as loyalty programs fill more than half of all rooms on a given night.
Reward programs pay off in another way: by coaxing mom-and-pops, which make up the vast majority of U.S. hotels, to give up their independence and join the leading chains. That allows them to offer reward points while benefiting from the lower commissions that big chains negotiate with online travel services.
In some cases, iconic or trendy hotels opt to be part of so-called soft or collection brands. In these arrangements, they loosely align themselves with a chain but keep their names and wield greater operating freedom in exchange for higher franchise fees.
Within the U.S., much of the growth today is coming from the construction of “select-service” offerings, which provide basic accommodations with no restaurants, spas, convention space or high-end amenities. Select service is popular among business travelers who prize consistency, modern technology and moderate prices. Franchisees like select-service hotels because they’re relatively easy to finance, build and operate, and tend to generate high profits.
U.S. hotel brands also have favorable prospects in underpenetrated international markets. Leading chains have only 5% market share outside the U.S. but plan significant expansion in coming years. In fact, big chains are responsible for half of the rooms that are expected to come online in the next few years.
Airbnb isn’t a significant threat to hotels.
Without question, one of the biggest trends in lodging has been the emergence of apartment-rental sites that match travelers seeking cozy rooms and cheap deals with homeowners eager for extra cash. But while Airbnb represents an important iteration, it projects less of a shadow than it might seem. These sites are primarily geared toward vacationers who book relatively long stays compared with the in-and-out dashes of peripatetic business travelers. And though Airbnb is siphoning off some hotel business, it’s running up against its own challenges, especially tighter regulatory limits as major cities worry that an onslaught of vacation rentals is crowding out residents.
Overall, the outlook appears to be favorable for leading hotel chains, which should continue to benefit from compelling business models, strong growth prospects and impressive brand recognition.
Matt Wilson is an equity analyst who covers the lodging industry. Based in Los Angeles, he has 10 years of investment industry experience and has been with Capital Group since 2013.
The above article originally appeared in the Spring 2018 issue of Quarterly Insights magazine.