Many longtime real estate investors will try to diversify their portfolios by investing in hotels. While this can be a great strategy if done properly, most real estate investors overlook the fact that owning a hotel property is much different than operating a hotel business. The two are intrinsically linked, but managing the hotel can prove to be challenging for those who are inexperienced.
In this article, we examine the most common mistakes made by hotel operators.
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1. Misalignment of Interests with Hotel Operator.
There are generally two ways to operate a hotel: the owner either self-manages the business or they hire a third party to manage the hotel on their behalf. In our opinion, the most successful hotels are those that are self-managed.
This is because self-managing properties gives the owner greater control over all aspects of the hotel, from hiring staff and training, to operational decisions and guest experience. This is especially important if the property has a unique vision or specific brand identity. Moreover, self-managing properties helps avoid costly fees if the owner-operator knows how to effectively manage the property in-house.
That said, we also recognize that not every hotel owner or investor has the capacity or interest in managing the hotel business. In these situations, there may be no other option than to hire a third-party management company.
However, one of the biggest mistakes we see is when there is a misalignment of interests between the hotel owner and third-party operator. This generally pertains to how the hotel operator is paid. Most will charge a minimum percentage of top line revenue. By way of example, we charge at least 3% of top line revenue on the hotels we manage on others’ behalf.
But how is the operator incentivized otherwise? An operator can easily beat revenue projections if they blow the budget. We have seen many hotels with fantastic top line numbers, beating market averages, but it comes at the expense of their bottom line. In fact, some will actually be running negative on the bottom line. This is a classic case of incentives being misaligned.
The gold standard is when a hotel operator will guarantee an ROI number. For example, we have worked with a company who guarantees at least $500,000 in revenue – otherwise, the shortfall is deducted from their contract amount. The management company earns “kickers” when it exceeds those revenue targets.
An alternative model is to create incentives based on hitting budget projections. This is similar to what you might expect with hurdle rates in real estate private equity. If the operator hits the projected NOI number, they get an additional 1% of top line revenue (bringing their fee from, say, 3% to 4%). If they beat the NOI number by a certain percent, say 20%, then their fee goes from 4% to 5%.
2. Sacrificing Guest Service.
All too often, we see operators so heavily focused on meeting their revenue targets that they sacrifice guest service in the process. For instance, they may reduce staff or eliminate some of their breakfast offerings. This might save money in the short-term, but it translates into guests who won’t want to return in the future.
Indeed, we place a high priority on guest surveys. After every guest stays, we send an automated survey asking them for their feedback and ratings in various categories, such as ease of check-in, cleanliness, and staff friendliness. We also ask whether guests would recommend the hotel to others.
These guest satisfaction surveys provide us with scores that we can peg to management contracts. In addition to having to meet certain NOI targets, operators should be expected to achieve a certain guest satisfaction score. Otherwise, the operator may have their contract terminated.
Guest satisfaction is important for several reasons but, most notably, failure to provide exceptional service can result in the hotel brand pulling the flag from that hotel. Losing, or the downgrading of a flag can ultimately be fatal to a hotel owner.
3. Failing to Account for PIP Implementation.
Overly-aggressive underwriting can be a downfall for any commercial real estate investor, regardless of asset class. However, something that is unique to the hotel industry is that these properties must be refreshed and new FF&E must go in every five to seven years; this is known as the Property Improvement Plan, or “PIP”, cycle.
A PIP is above and beyond normal repairs and maintenance, for which hotel owners should already hold about 4% in reserves each year. Owners will want to carry a separate budget for PIP implementation—something that many first-time owners forget to do. This is a major cost that can drastically impact an owner’s underwriting. Depending on market conditions, an owner may be able to refinance the property and take cash out to implement the PIP. But in a rising interest rate environment, this may prove to be challenging. The economics simply may not work at higher interest rates.
This is especially problematic for someone who purchases a hotel midway through that PIP cycle. For example, someone who takes over ownership in Year 4 will be facing major improvements in the near future. A PIP is required by any flagged hotel and includes things like replacing signage, replacing all beds, furniture, all carpets, and more. This is another costly mistake that again, can put an owner’s flag at risk.
4. Fixating on Occupancy at the Expense of ADR.
A lot of first-time owner-operators, especially those who have previously invested in multifamily, are overly fixated on increasing occupancy to the detriment of the business. They might, for example, purchase a hotel that’s running at 75% occupancy and work to increase occupancy to 90% or more. The easiest way to do so is by dropping nightly rates (referred to as “average daily rates” or ADR) relative to local competition.
But this typically proves to be a fool’s errand.
As most experienced operators know, occupancy and ADR are inversely related. The higher the occupancy, the lower the ADR, and vice versa. Striking a balance between the two is essential. To do this, an operator must know where they have the most efficiency.
Let’s consider the hotel operator that reduces ADR to increase occupancy from 75% to 90%. At 75% occupancy, the hotel could turn rooms over with just four housekeepers. About 25% of rooms were vacant, leaving some room for margin if a room didn’t get turned over in time. Running at 90% occupancy might mean hiring a fifth housekeeper or paying your current staff overtime. There is more wear and tear on the property. There’s also very little margin for error with turning rooms over in a timely manner.
Moreover, more heads in beds means more linen service is needed, more breakfast is consumed, and more of those little bars of soap and other toiletries get used.
As you can see, there comes a point where it is less profitable to increase occupancy than to maintain your existing ADR. This is a concept that takes some first-time hotel operators time to grasp and can be a costly mistake in the process. The key is to carefully analyze operating financials to determine the most efficient occupancy rate based on your specific hotel type.
5. Mismanaging Labor and the Associated Costs.
There’s no doubt: appropriately hiring, training, and managing staff is no easy task, even for the most adept hotel operator. Dealing with personnel issues is difficult regardless of the industry, but hospitality tends to have lower-wage and more transient staff than other industries. This is why we believe in paying fair, appropriate wages while ensuring staff are well trained. We find that this is the best way to promote employee retention. Well-trained and motivated staff are also essential for delivering exceptional service.
Most hotel operators would probably agree. Yet, we still find staffing to be a challenge for many hotel operators. Some will try to hire through a third party where staff are essentially contractors to the hotel. Not only does this drive up costs, but then we lose the control over overtime hours.
Payroll is the single largest expense for any hotel operator. If you are not properly controlling payroll, you could be losing upwards of 10% of your potential profit each year.
6. Having an Ineffective Sales Strategy / Lack of CRM System.
Many hotel operators overlook the importance of their sales strategy. This is a multi-dimensional problem.
First is not understanding your target market. Lacking knowledge about the hotel’s target market can lead to ineffective marketing strategies and guest experiences that do not align with guest expectations.
Second is when hotel operators do not utilize a CRM system to track their sales efforts. Onboarding a new CRM system can be both difficult and costly, but it ultimately pays for itself. A CRM system can provide valuable insights as to how effective your sales efforts are.
To that end is proper sales staffing and training. Are your salespeople using a script? How often is that script being reviewed? Are they logging their contacts in the CRM system? This helps increase sales efficiency—a metric that considers the cost and time it takes for a salesperson to convert people into paying guests.
Finally, an effective sales strategy (i.e., one that uses a CRM system!) will also include occasional email marketing communications to past guests to ensure they are aware about any upcoming promotions, etc. Staying in close contact with prior guests is a great way to boost sales among returning guests.
7. Forgetting to Recondition Contracts.
Another common mistake is when hotel operators renew contracts without paying close attention to the details or terms of those contracts.
There are two types of contracts to consider. The first are the contracts the hotel has with third-party vendors, such as their linen service or payroll company. These contracts are generally renewed on an annual basis. Many will propose increased rates that can all be negotiated by a shrewd hotel operator. Reviewing and reconditioning all third-party contracts is essential when it comes to operational cost control.
The other contracts are those that the hotel has with corporate accounts in which the corporation can have its employees stay at the hotel for a pre-negotiated rate. For example, a construction company that does routine work at a naval base might sign a contract with a local extended-stay hotel where their employees can stay at a $69 nightly rate. Many hotel operators will re-sign those agreements year after year without building in an escalator. Now, five years after the original contract was signed, the company is still paying the same $69 rate – something that could have increased with a 3% annual increase built into the original contract.
While a 3% annual increase may not seem significant, consider that corporate accounts like these will often have 800+ room nights any given year. A 3% increase on this sort of volume is more impactful than operators realize.
8. Not Having an “Owner’s Mindset”.
Unfortunately, some hotel operators lack the “owner’s mindset” that is so crucial when running a profitable hotel business. An owner’s mindset requires the hotel operator to make each decision in the context of the bigger picture. It forces operators to consider whether certain costs are warranted or could be minimized, and what impact these costs will ultimately have on the bottom line – because as an owner, the impact on the bottom line has a direct impact on your profit.
Here is a real-world example that we have faced.
A washing machine breaks, which is a critical piece of equipment, especially for hotels that manage their laundry service on-site. A commercial washing machine can easily cost upwards of $15,000. Facing a potential crisis of not being able to complete laundry service in time for guest turnover, an inexperienced hotel operator might quickly purchase another machine. In our case, we called in a repair technician who told us that he simply needed to repair the motherboard which would only cost us $200.
Having this owner’s mindset is especially important when navigating capital expenses, as these big-ticket items can quickly erode annual returns.
No hotel operator is perfect. We all make mistakes. However, we believe there is no replacement for the experience gained as a truly hands-on owner-operator. We have navigated challenges like these over the years, often learning lessons the hard way. Yet we have been able to adapt and have come out stronger on the other side. We take this knowledge to each new property we acquire to ensure we are operating the most efficient—and most profitable—hotel on our investors’ behalf.