Overall, the strong economy has been a blessing for U.S. hotel managers. However, it also presents some operational challenges. Hotels have been the beneficiaries of strong increases in demand that have resulted in tremendous gains in revenue. However, the inflated costs of such expenses as property taxes, utilities, and labor have inhibited the flow-through of top-line dollars into bottom-line profits.

In 2005, the cost of operating a U.S. hotel grew 6.5 percent. Leading all expenses in percentage growth were utilities that grew 13.6 percent from 2004 to 2005. The largest cost center, labor and related expenses, increased by 5.1 percent last year, creating another drag on profit growth. Hotel managers have some degree of control over expenses like labor, but limited control over contractual or municipal costs such as management fees, franchise fees, property taxes, insurance, and utilities.

The 2006 Trends in the Hotel Industry report marks the 70^th annual review of U.S. hotel operations conducted by PKF. This year's sample draws upon year-end 2005 financial statements received from approximately 5,000 hotels across the country. Profits are defined as income after management fees, property taxes, and insurance, but before capital reserves, debt service, rent, income taxes, depreciation, and amortization.

More Properties Benefit

Unlike 2004, a wider variety of properties started to benefit from the industry upswing during 2005, the second year of recovery from the 2001-2003 recession. In 2004, we observed that the larger hotels with higher room rates experienced the greatest increases in profitability. In 2005, all five property types in our Trends survey achieved strong gains in total revenue, as well as double-digit increases in bottom-line profits. PKF-HR breaks down the Trends survey sample into five property categories: full-service, limited-service, convention, all-suite, and resort.

Among the different property categories, limited-service hotels achieved the greatest increase in revenue (10.3%), while full-service hotels achieved the greatest increase in profitability (19.3%). While convention hotels lagged the other property types somewhat in terms of revenue and profit growth, the 7.8 percent gain in revenues and 12.2 percent increase in profits posted by these hotels are well above the long-term averages for this segment.

Components Of Revenue Growth

For the hotels in PKF's 2005 Trends sample, a 2.9 percent increase in occupancy combined with a 7.4 percent increase in ADR to generate a 10.4 percent increase in RevPAR. This favorable mix of RevPAR drivers was the primary reason for the high growth in profits achieved in 2005. Following typical market recovery scenarios, we expect ADR growth to dominate RevPAR increases in the next few years. In fact, the Spring 2006 Hotel Outlook forecast prepared by PKF Hospitality Research and Torto Wheaton Research calls for ADR to grow 4.7 percent in 2006, while occupancy growth slows to 1.5 percent.

In 2005, revenues from all other minor-operated departments did not keep pace with the significant rise in rooms revenue. The combined revenues from the food department, beverage department, telecommunications, other operated departments, and rentals and other income increased by 5.6 percent from 2004 to 2005. Since guest count is frequently the impetus of sales for these supplemental operated departments, this comparatively slow growth rate can be attributed to the fact that the number of rooms occupied grew only 2.9 percent in 2005. Fortunately, the cost of operating these other departments grew just 4.3 percent, thus revealing that the minor-operated departments did contribute to the increase in overall hotel profitability.

Not contributing to the increase in bottom-line profits was the telecommunications department. Sales in this department dropped another 7.6 percent in 2005, the fifth consecutive year of revenue declines.

Expenses Grow With Business Volume

Total operating expenses for the hotels in the Trends sample grew 6.5 percent in 2005, double the 3.3 percent rate of inflation for the year. As we have seen in the past, strong growth in revenues was able to mask significant increases in the cost of operating a hotel. The following paragraphs highlight the change in select operating expenses during 2005.

- Labor Costs

At 44.6 percent of all operating expenses, labor and related costs continue to represent the largest expense item for hotels. Therefore, the 5.1 percent increase in labor and related costs incurred during 2005 contributed significantly to the 6.5 percent increase total hotel operating costs. For the second year in a row, it was the rise in employee benefits that overshadowed the increase in salaries and wages. In 2005, the salaries and wages paid directly to hotel employees went up 4.6 percent, while employee benefits rose 6.4 percent.

- Rooms Department Costs

In 2005, rooms department expenses increased 7.3 percent, the single largest increase for any revenue-generating department. Most of the rooms department expenses are variable in nature; therefore, a portion of the rise in departmental costs can be attributed to the increase in business volume (more rooms occupied and more guests). However, amenity creep (free wi-fi, enhanced bathroom products, in-room guest service technology, upgraded bedding, etc...) as once again surfaced, which impacts the day-to-day operating expenses of the rooms department.

- Fees

Two of the most significant cost increases in 2005 have been in management fees (8.9 percent) and franchise fees (9.8 percent). This makes sense since a large portion of these costs is often charged as a percentage of revenue. Analysis of these cost categories reveals some interesting results.

In the past few years, royalty fees and marketing assessments have gone up and down in sync with annual changes in rooms revenue. However, not moving in-step with revenue have been the charges for guest loyalty programs. An increasing number of hotels are reporting guest loyalty program charges as a separate and distinct expense item as this cost becomes more significant. While hotels appear to be benefiting from the increased use of loyalty program privileges, this rise in activity does come at a cost.

In 2005, the management fees (base and incentive) paid by the hotels in PKF's Trends sample increased by 8.9 percent. This compares to an increase in total revenue of 8.8 percent. With total management<