PREDICTIVE POWERS OF HOTEL CYCLES

By John (Jack) B. Corgel, Ph. D

Whether we want to accept the fact or not the hotel business (both the sale of rooms and assets) is a cyclical business. Cycles exist in the hotel business for some good and well documented reasons. Most importantly, hotels are not the same as most other commodities like, say, tooth paste. By this I mean that when the demand for rooms suddenly spikes, as it did during the recent holiday season in New York City, the supply of rooms cannot correspondingly expand within a short period to satisfy the new level of demand. Should the same circumstances occur in the market for toothpaste, producers will turn up the machinery not operating at full capacity, add another work shift, and turn out more tubes before you can say 'dental bills.' Thus, hotel supply change lags demand in both the upward and downward directions meaning that RevPAR persists at relatively high levels and growth rates following an upward movement in demand and RevPAR persists at low levels and growth rates following a decline in demand.

The cycle's story just told appears quite tragic unless participants are somehow clever enough to predict the turning points and avoid downturns and troughs. Despite the financial wreckage they created in the past, hotel cycles now generate some underappreciated predictive powers. These powers are fueled by the availability of Smith Travel Research and other data covering a complete cycle ( i.e., down from 1987 to 1992, up from 1992 to 2001, and down from 2001 until quite recently). During the latest complete cycle, all the moving parts behaved much as economic theory suggests. If the hotel market recently made an upward turn at the bottom of the cycle as many feel, then we have in our possession the map of how a recovery will unfold. In this article, I attempt to use the knowledge gained during the latest complete cycle to chart a near-term course of events in the U.S. hotel market.

OCCUPANCY AND ADR CYCLING THROUGH TIME

The existence of hotel market cycles is a well-recognized phenomenon.¹ Smooth and regular fluctuations around an equilibrium level may occur for two reasons. First, a strong correlation exists between measures of national and local market economic activity ( e.g., GDP, real personal income, and employment) and hotel demand. Consequently, cyclical patterns in hotel performance measures emanate from business cycle patterns through the demand side of the market. Second, supply changes should logically follow shifts in demand, albeit with long delivery lags. If the business cycle is smooth and construction predictably responds, then the hotel market cycle will have a correspondingly smooth appearance over time.²

Abnormally wide swings in hotel market performance observed during recent decades occurred because of shocks to the economy and hotel markets. These events either impacted the supply of hotel rooms, demand for hotel room nights, or both. Government intervention of the early 1980s, for example, artificially inflated the supply of hotels. With occupancy already below normal levels in the late 1980s, the recession and Gulf War in the early 1990s stymied the market recovery. Similarly, the combined effects of the demand-based general economic recession beginning in 2001, the terrorist attacks in September 2001 that created a stigma on domestic and international travel caused demand for air travel, and the Iraqi war produced steep declines in hotel occupancy and average daily rate (ADR) during 2001 and 2002.

Exhibit 1 shows the cyclical patterns of occupancy and real ADR for U.S. hotels during the past few decades. The following observations come from an examination of these trends:

Source: PKF Consulting

1. Occupancy has a definite cyclical pattern. This pattern appears smoother since the late 1980s, which may be the consequence of lower information costs.³
2. The pattern of real ADR also appears cyclical, albeit with an upward trend.
3. During two periods, 1972-1974 and 1985-1987, occupancy and real ADR moved in opposite directions. These atypical and anomalous movements are likely the result of the federal government policies in place during those respective times.⁴
4. Since the early 1990s, and for some years before 1990, occupancy leads ADR just as economic theory predicts.

The economics of hotel markets suggest that occupancy represents the current relationship between demand and supply. Occupancy reaches levels above (below) normal when demand exceeds (less than) supply. During periods of abnormally high (low) occupancy, ADR increases (decreases) causing occupancy to fall (rise). The economics of hotel markets also suggest that ADR represents the current relationship between demand and supply, and accordingly, ADR reaches levels above (below) normal when demand exceeds (less than) supply. Once ADR reaches a level in the market for which development becomes feasible. To complete the market process, hotel construction eventually satisfies the excess demand that drove occupancy and ADR above normal. As more rooms are added to the stock, occupancy and ADR fall back to normal levels. At the peak of the cycle the market may become unstable with supply growth continuing after demand is satisfied (i.e., overshooting). This problem of overbuilding is an unfortunate byproduct of cyclical markets.

Exhibit 2 presents a graphical representation of the hotel market cycle. The hotel market process involves an observable lag between occupancy change and ADR adjustment.⁵ As markets move from the peak of the cycle to the trough, such as during the recent cycle phase from 1998 to 2002, softness in demand forces hotel managers to reduce room rates in an effort to maintain occupancy percent.⁶ These actions retard the decline in occupancy during periods when demand drops. The opposite of this process occurs as markets move from the trough of the cycle to the peak. An increase in the demand for hotel rooms causes immediate improvements in occupancy. The upward trend in occupancy moderates as hotel managers begin to raise room rates, which begins occurring as occupancy approaches the natural level of the market. Exhibit 3 provides a summary of how markets 'should' behave through an ordinary cycle and in response to external events.

Exhibit 3: Hotel Market Processes in a Normal Cycle and Following Extraordinary Events

Market Condition