Anyone who is considering investing in a hotel will first want to learn about hotel industry economics. Hotel economics revolve around revenue generation, cost management, and profitability. These will vary depending on the type of hotel – e.g., luxury vs. limited service – and the business model. In this article, we take a closer look at what drives revenue at hotel properties, including the biggest costs that hotel operators should be prepared to incur.
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The Economics of Select-Service Hotels
Select-service hotels, also referred to as “limited service” hotels, are by far the most common hotel type in the U.S. This is true in terms of number of hotels as well as total key count (number of rooms). Select-service hotels typically draw budget-conscious travelers who tend to stay for one or two nights at a time. These hotels usually have few, if any, amenities.
Room Revenue: The primary source of revenue for any hotel is room revenue, generated through the “sale” of guest rooms. Select-service hotels typically offer room rates at a more affordable price point compared to full-service hotels, making occupancy a critical factor in revenue generation. Roughly 95% of all revenue at select-service hotels is room revenue.
Food and Beverage Revenue: While select-service hotels may not have full-service restaurants, they often offer breakfast services, limited dining options, and sometimes snack bars or vending machines. Food and beverage revenue contribute to overall income.
Meeting & Event Space: Some select-service hotels have small meeting rooms or event spaces that can generate additional revenue from business meetings, conferences, and social events.
“Other” Revenue: As noted above, select-service hotels have very few amenities like on-site dining or spa facilities. Therefore, any “other” source of revenue is limited. This may include selling movies or coin-operated laundry.
Labor Costs: Labor is by far the biggest expense for any hotel type. At limited-service hotels, labor accounts for approximately 30% of all expenses. Hotels are very labor intensive. The best house cleaners can clean rooms in just 10 to 15 minutes, depending on the size of the room and flooring types (e.g., laminate vs. carpet or some combination). However, limited-service hotels tend to turn over every night or every few nights (people stay 1.5 days, on average), which means rooms need to be continually cleaned. On off nights, where rooms do not turn over, those rooms may still need trash, linen, or bed service.
Administration Costs: Admin costs include paying the general manager, sales, and marketing costs. This usually constitutes about 10% of top line revenue.
Franchise Fees: Any “flagged” hotel that operates as a franchise, e.g., a Hilton Garden Inn operating under Hilton Global, will need to pay anywhere between 8-10% of their top line revenue to the parent company. This is usually 5-7% for revenue management and another 3% of room revenue.
Repairs & Maintenance: Typically, on a 100-key hotel, the owner should budget for approximately $1,000 per year per room in necessary repairs and maintenance. This includes having to replace TVs, microwaves, AC wall units, carpet, repainting walls, and more. Select-service hotels tend to incur more “normal” wear and tear than luxury hotels and turn over more frequently – meaning they see more guests, on average.
Utility Costs: Utility costs, like water/sewer and electricity, generally cost about 3-4% of top line revenue.
Taxes and Insurance: In addition to normal property taxes, hotels may be subject to specific municipal taxes or fees that only apply to lodging establishments, “transient occupancy tax” or TOT, for example, that is passed through to guests. Property and business insurance also tends to be higher for hotels given the transient nature of the guests; insurance companies deem hotels to be “higher risk” than other property types.
Reserves: Most hotel operators will set aside between 3-4% of top line revenue, either willingly or as required by their franchisor. This money is typically held in an escrow account and ensures there is sufficient funding available for when the hotel’s Property Improvement Plan (PIP) comes due, usually every 7 to 14 years, which requires a refurbishment of the room’s FF&E.
After all of revenue and expenses are accounted for, select service hotel operators can expect to generate somewhere in the mid- to high-30% range in terms of profit. In the hotel industry, this is referred to as the “flow-through” which is essentially the profit margin or EBITDA. Flow-through is calculated by dividing net income (revenue minus expenses) by total revenue.
The Economics of Luxury Hotels
Luxury hotels have a much different economic model than select-service hotels. There are more revenue streams and also different expenses that can be much more costly given the high-end products that luxury hotels use.
Room Revenue: Room revenue continues to be the primary driver of revenue at luxury hotels, but the percentage of total hotel revenue is significantly lower than at select-service hotels. At luxury properties, room revenues may only account for about 70% of total revenue. The remaining 30% of revenue comes from the various sources listed below.
Food and Beverage Revenue: Luxury hotels will usually have at least two full-service dining options. Fine dining restaurants, bars, and room service offerings are common in luxury hotels. Revenue is generated through the sale of food and beverages, including breakfast, lunch, dinner, snacks, and alcoholic beverages.
Spa and Wellness: Luxury hotels often have high-end spa and wellness facilities, including massage services, boutique fitness centers, and wellness programs. These services can generate substantial revenue from both guests and external visitors.
Event and Meeting Spaces: Luxury hotels frequently offer banquet halls, conference rooms, and event spaces for weddings, conferences, and other special occasions. Revenue is generated from event bookings, catering, and related services.
Retail and Boutiques: Many luxury hotels have on-site boutiques and shops offering high-end fashion, jewelry, and other luxury items. These retail spaces generate revenue from both guests and external shoppers.
Tour and Excursion Services: Luxury hotels often arrange tours and excursions for guests to explore the local area. They can earn commissions from these services.
“Other” Revenue: Luxury hotels often offer personalized services, such as airport pickups or car rents, all of which are available for a fee.
All of the costs listed above for select-service hotels also apply for luxury hotels. There are a few key points of differentiation, however, which we outline below.
Labor Costs: Labor costs are especially high in the luxury hotel market. They can be two or three times higher as a percentage of revenue than on a select-service hotel. This is because luxury hotels have significantly more staff than other hotels. At a 200-key luxury hotel, there could easily be 100 to 150 staff members. These might not all be full-time employees, but many of them will be.
Moreover, luxury hotel workers often command high hourly and salary rates. It’s not uncommon to pay staff members at least $25 to $35 per hour, depending on the market, versus minimum wage at select-service hotels. In some markets, the hotel operator might also need to pay for employee housing. This is common in destination vacation markets where housing is seasonal and/or very high.
In a market like Park City, a luxury hotel operator would not be able to fill any vacancy for $15/hour without also paying for housing because employees simply would not be able afford housing on that salary. Therefore, some hotel operators will buy an apartment building or lease a block of rooms to house their staff.
Replacement Costs: Replacement costs for items at a luxury hotel are also significantly higher than at other hotel properties. Unlike select-service hotels, which prioritize cost effective and budget-friendly materials like flooring and wallpaper, luxury hotels often invest in extravagant finishes. There could be a $45,000 chandelier at the property. Individual rooms also feature higher-end finishes, with more glass, tile, and high-end fixtures common in bathrooms.
Technology: Luxury hotels invest in cutting-edge technology for reservations, guest management, room key systems, and guest experience enhancements which can be costly to acquire and maintain.
Carrying Costs: The carrying costs for luxury properties, especially insurance, tend to be higher than at select service hotels. Insurance is higher, for example, because the owner is insuring higher value items.
A well-run luxury hotel will run at about a 30% profit margin.
What Do Guests Value Most?
Most hotels will use “satisfaction” scores to determine where they need to reinvest or make adjustments at their properties. These satisfaction scores are derived from the guest surveys provided after a stay. These surveys provide a lot of data on a specific hotel and tell how people felt about their stay.
In the select-service market, the number one priority of guests is – and will always be – room cleanliness. People care about having a clean bed, a clean bathroom, and a room that truly feels cleaned properly. This was especially important during and since the Covid pandemic. To that end, providing the appropriate number of pillows, towels, hand towels, etc. is also important to guests.
Staff friendliness also ranks as important to guests. Here at Wolfgramm, we tend to use a “five and ten” rule: when the guest is 10 steps away, staff should look up and make eye contact. When someone is five feet away, acknowledge them with the appropriate good morning, good evening, etc. This makes people feel welcome at our hotels.
At select-service hotels, people also value breakfast. For budget-conscious travelers, saving $30 or $40 on breakfast for their family can be significant. Breakfast should be prepared on time, with a mix of hot breakfast items and cold grab-and-go options.
Finally, at both select-service and luxury hotels, appreciation for a guest’s elite status also matters. Some people are die-hard brand loyalists and will only stay at the Hilton, Marriott, IGH, and so forth. When checking in, they want the person behind the counter to acknowledge their status and then treat them slightly differently than they would non-loyalty members. Staff should be well-trained to show their appreciation to members with elite status and acknowledge that the hotel is happy to have them back.
How to Points/Hotel Reward Systems Work?
Many guests will pay for their hotel stay using the brand’s loyalty or rewards points. How these points factor into the economics of a hotel is extremely complicated, largely because the algorithms that brands use to calculate reimbursement rates have changed and continue to change over time.
In short, rarely will a hotel get a 1-for-1 reimbursement from the parent company when a person books using reward points. Instead, most hotels are forced to subsidize these guest stays. For instance, if someone uses 20,000 points to redeem a one-night stay valued at $100, we may only get $25 back from the franchisor for that room.
The big exception is when a hotel achieves a certain level of occupancy – typically, 85%+ occupancy. Once they hit that threshold, the franchisor will then reimburse the hotel for the full value of the rooms for all rooms booked with points on that evening.
Let’s say a hotel hits 85% occupancy. For every room they book above 85% occupancy, they will get that full $100 redemption.
As you might imagine, this can lead to some operational gamesmanship.
If a hotel is at 84% occupancy mid-way through the day, an operator might drop the room rate for that evening to encourage last-minute bookings or walk-in guests looking to take advantage of the lower rate. While the hotel sacrifices on that one room’s rate for the evening, they in turn exceed the 85% benchmark which allows them to redeem the full value of the rooms booked with points (usually worth more than the discount offered to the guest putting them over the threshold’s top). Now, instead of getting $25 per redemption, the hotel gets $100 for all of the rooms booked with points.
Here's why this happens: the hotel parent company (e.g., Hilton or Marriott) makes their money off the franchisee’s top line revenue, so they want to incentivize franchisees to maximize their occupancy even at the expense of what might be an efficient rate. As an owner, it might be more efficient to charge more per room and run at 70% occupancy because the costs are lower (i.e., same revenue but lower costs). If a hotel charges a lower rate to increase their occupancy, the parent company gets more of the top line revenue, but the owner is paying higher costs (e.g., staffing) which usually does not make up for the increased revenue earned between 70 to 100%.
This is also why sometimes a brand will charge 75,000 in points for a room on some days, but only 20,000 in points on other days. It all depends on how expensive it is for the brand to honor your points, which will depend on where the hotel is tracking with occupancy at that time. If occupancy is running high, the brand will require guests to spend more points because the brand knows it’s going to have to pay for all of that hotel’s points once they hit a certain occupancy.
The Value of STR Reports
The hotel industry relies heavily on STR (pronounced “Star”) reports. STR reports are created by a company originally known as Smith Travel Research, STR. The reports they create compare a hotel’s performance metrics with a predetermined competitive set of other hotels and are used universally in the hotel industry to set pricing, motivate staff through incentives, and for myriad other uses.
Owners select a comp set, usually the same type of brand (e.g., you wouldn’t compare a Ritz-Carlton to a Fairfield Inn & Suites) and typically within the same geography. For instance, you would not want to compare hotels in Austin to Dallas or Houston because most travelers are set on going to one of these markets – not all three. The exception is with luxury destination markets, where individuals may be looking for a high-end ski vacation and are willing to choose Park City vs. Wyoming or Colorado.
Assuming the hotelier has selected the appropriate comp set, the STR report will be highly valuable.
The STR report tells you how much the comp set is charging for average daily rate (ADR), even as fine-grained as ADR per day of the week. It also shows the occupancy rates and revenue per available room (RevPAR). The data is not presented on a hotel-by-hotel basis, but rather averaged across the comp set.
These data are very telling. For instance, if your hotel is running at 100% occupancy and you are charging $100/night, then your hotel’s RevPAR is $100. If you’re only at 50% occupancy, then your RevPAR is $50. Metrics like these are then indexed. If other hotels are charging $100 and an operator is charging $150, then the RevPAR index would be 1.5, assuming occupancy is the same.
The STR report will show you how your hotel compares against those other hotels, using 12-month trailing data to show how your property and the comp set’s trendlines have changed.
Understanding how a hotel rates relative to the competition helps owners make informed decisions about capital improvements, room upgrades, their marketing effectiveness, their target demographic, and more. Those who outperform their competition will want to ask why: are the other hotels older? Are they further from the freeway? There may be some fundamental differences that result in higher ratings.
The STR report also matters to employees because many hotels offer bonus incentives that are pegged to the STR report and the hotel’s overall performance.
The Key Metrics for Hotel Economics
There are a handful of economic metrics that are specific to hotel operators. These include:
- Hotel Age: The age of a property will tell you about projected and ongoing maintenance. Older hotels may require more extensive and costly maintenance and renovations to keep their facilities in top condition. Aging infrastructure, outdated amenities, and wear and tear can result in higher ongoing expenses which can reduce profitability.
Hotel age is also tied to guest expectations. Travelers’ expectations for accommodations have evolved over time. Modern hotels often feature updated amenities, technology, and design elements that cater to contemporary preferences. Older hotels may struggle to meet these expectations and can lead to lower guest satisfaction and repeat business.
- Key Count: This is especially important as it influences hotel occupancy and RevPAR. For example, we recently passed on buying a 142-key hotel because the hotel was never able to achieve more than 60-70% occupancy. They were charging the same ADR as their comp set, but their lower RevPAR was a result of having too many rooms. Area hotels with 80-100 keys were consistently occupied, but 142 rooms was simply too large given current market demand. The hotel was overbuilt and we would never be able to hit our desired RevPAR numbers.
- ADR and Occupancy: The Average Daily Rate, or ADR, is a key performance metric used to measure the average price or rate at which hotel rooms are sold over a specific period, usually one day. ADR is an important indicator of a hotel’s pricing strategy and revenue management performance. To calculate ADR, simply divide Total Room Revenue / Number of Rooms Sold.
Often, we find that multifamily investors who try to invest in hotels using the same mindset will be unsuccessful. In multifamily the goal is to maximize occupancy. Using that strategy as a hotelier could result in a drop in ADR. These are inversely related metrics. It is possible to have 100% occupancy if you charge just $1 per night, or 0% occupancy if you charge $1,000 per night. There is nuance to getting somewhere in the middle to optimize the profitability and performance of a hotel.ADR is often used in conjunction with other performance metrics, such as Revenue Per Available Room (RevPAR) and Occupancy Rate, to provide a comprehensive view of a hotel's financial health and operational efficiency. These metrics collectively help hoteliers evaluate their pricing strategies, market positioning, and overall competitiveness within the industry.
- NOI-PAR: This stands for net operating income per available room. This is not a metric that is available on the STR report, but it is important to hotel operators as it helps to evaluate the hotel’s profitability and financial performance. NOI-PAR is calculated as NOI minus Replacement Reserves.
NOI-PAR can tell owners a lot about the hotel’s management – or mismanagement. For example, we recently purchased a Marriott hotel where the prior owners were charging $100 per night at 80% occupancy. We were able to go in and increase the rates to about $180 per night while maintaining 73-74% occupancy. This allowed us to increase revenue by 60% within 8-12 months. We did so by making better informed decisions about the property’s maintenance, renovations, and overall financial planning for this property.
- Time Remaining on Franchisee License: Prior to acquiring a new hotel property, we also look at how much time is left on the franchisee license. Most licenses are good for 10 to 20 years. There is inherent value to that license. If there are only two years remaining on the license, and if the franchisor has indicated it does not plan to renew that license for whatever reason, then the value of the hotel immediately goes down, sometimes by 30% or more.
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The type of hotel, including whether it is a franchise of a larger hotel chain, will almost always impact its core economics. The examples we gave here today are based on our experience operating both limited service and luxury hotels. In both cases, this requires a careful balance between managing revenue and operations, with a strong emphasis always placed on maintaining a strong brand reputation.
As we have shown, those who manage a hotel effectively will find them highly profitable – with flow-through rates of 30-35% or more.
If you’re interested in investing in the hotel industry, contact us today to learn more.