HOTELIERS UNDERESTIMATED 2007 PROFITS
Will They Lowball 2009?

by Robert Mandelbaum and Steven Nicholas CHA

PKF Hospitality Research has been tracking the accuracy of hotel budgets since the late 1990s. During this time, we have learned that hotel managers are very adept at budgeting during prosperous periods for the lodging industry. However, when the industry suffers through a slowdown, the accuracy of hotel budgets deteriorates dramatically. Under poor market conditions, hotels have missed their profit targets by as much as 20 percent.

Why are hotel budgets less accurate during industry recessions? Are hotel managers eternally optimistic, or maybe they are just lucky in years of strong performance?

Budgeting Through Cycles

The process of budgeting tends to be much less complex process in optimistic times than in times of concern. During industry upswings, investments are achieving their desired results. Lenders are collecting their debt service; investors are receiving their returns, management companies are earning their incentive fees, and lodging stocks are climbing.

When RevPARs begin to taper off, all of this goes away, or at least slows down. Not only do new deals decelerate, but the fees and returns that were assumed in current investments are not being achieved. This completely changes the dynamics of the budget process. At this point every revenue and expense line item is reviewed multiple times. General managers, regional senior vice presidents of operations, chief operating officers, asset managers, loan servicers, owners and all their partners look for opportunities that may have been missed in the past. Revenue opportunities are estimated, and operators are challenged to find savings in excess of what they have achieved in the past. The interesting part of the process in down times is that the final budget is frequently decided by people that may have never been to the property.

While lodging is referred to as a predictable cyclical industry, it is the timing of the cycle that has proven to be elusive. During the post 9/11 period every predication had the business environment improving in the “next” quarter, whether that next quarter was second quarter of 2002, or third quarter of 2002, or each successive one after that. Hotels budgeted modest declines for 2002 and flat RevPARs in 2003 only to fall short of these numbers by enormous variances. It was not until the budget process for 2005 that this pattern changed. After four years of declining, flat, or slightly positive growth, most experts believed that 2006 was going to be a year of slow growth and hoteliers budgeted accordingly. Ultimately, 2006 was a year that operators beat their budget by a large amount.

Hotel managers are currently tasked with forecasting the 2009 revenues, expenses, and profits for their hotels. All signs point to a soft economy and slowdown in travel. Are hotel operators prepared to submit business plans that call for a decline in operating performance?

To assist U.S. hotel management in the preparation of their estimates for 2009, we have examined the accuracy of 500 hotel budgets for the year 2007. The data was taken from the Trends in the Hotel Industry database of PKF Hospitality Research.

Budget Accuracy

Looking towards 2007, the hotel managers in our survey sample were budgeting for a 7.0 percent increase in total revenue. At the end of the year, total revenue grew a healthy 6.4 percent, but did fall short of the budgeted revenue target by 0.5 percent.

The main reason for the revenue shortfall was an overestimation of the number of rooms expected to be occupied. The properties in our research sample budgeted for a 2.0 percent increase in occupied rooms in 2007, but actually accommodated only 0.4 percent more than 2006. Fortunately, hotel operators remained relatively aggressive in managing their room rates. In 2007, average daily rates (ADR) for the sample grew 6.8 percent, 0.9 percentage points greater than the budgeted growth rate of 5.9 percent.

Exceeding budgeted ADR was welcome news, but still not enough to overcome the deficit in occupancy. The net result was a 0.9 percentage point shortfall in rooms revenue (RevPAR). Since rooms revenue comprised 64.5 percent of total revenue for the hotels in our survey sample, this explains most of the underperformance in budgeted total revenue.

Facing less revenue growth than expected, the hotel managers in our survey reacted by controlling their costs. Total operating expenses (operated departments, undistributed departments, fixed charges) were budgeted to grow 6.9 percent from 2006 to 2007, but only increased 5.0 percent. Part of the moderation in expense growth can be attributed to the reduced occupied room count and corresponding reduction in the variable expenses that would have been needed to serve these rooms.

With expenses falling 1.7 percent short of their budgeted amount, the hotels in our survey sample were able to exceed their targeted net operating income1 (NOI) despite the disparity in revenue. NOI was anticipated to grow 6.3 percent in 2007. Instead, the sample properties enjoyed a very strong 10.4 percent boost to the bottom-line. At the end of the year, hotels beat their budgeted profit levels by 3.8 percent.

The Budget Process

Historical market penetration and forecast reports from external sources provide management with the underlying basis for the budget. These reports present the historical market conditions in which the hotel has operated, and paint the picture of the market in which the hotel will compete in the future. After reviewing these reports, the next step for the budget team is to ascertain what the hotel can do to improve its performance in the following year. Can they grow market share, steal customers, or induce new demand on their own? On the expense side, can they cut positions, reduce amenities, increase productivity, or purchase cheaper goods and services?

Unfortunately, during periods of prosperity, many people believe that management becomes stale and unimaginative when preparing their budgets. It is assumed that new sources of revenue and overinflated costs will simply repeat themselves in the following year. Fortunately, during the recent up-cycle, the inclusion of more sophisticated labor expense reporting, central revenue management, and other tools has provided more detailed data to a more extensive audience and kept much of the excessive budgeting to a minimum.

Over the years, the number of people involved in the budging process has grown. Historically, the budget process was virtually the exclusive domain of the operations de