Hold Those Rates!  Discounting in a Competitive Environment

As the accommodation market continues to face increased challenges as a result of a far reaching global economic crisis, the industry at large is diligently working to minimize the bottom line impact and attempting to secure market share in a heightened competitive environment.

While many operations stand to benefit from these efforts such as cost trimming exercises, contract re-negotiations, and staff redundancies, some of the tactics adopted by operators in survival mode can be detrimental to the hotel and market alike.  At the forefront of such tactics is Rate Discounting.

This issue of discounting is hardly a novel concept and considerable research has been undertaken by the academic community over the years to understand the implication of various pricing strategies.  Some of the most prominent research was conducted by Cornell University in two separate studies: “Why Discounting Doesn’t Work:  the Dynamics of Rising Occupancy and Falling Revenue among Competitors” (Canina and Enz, 2004) and “Why Discounting Still Doesn’t Work” (Canina and Enz, 2006).  The conclusion of both studies showed that discounting relative to a competitive set resulted in a lower RevPAR, even though relative occupancy increased.

However, as operators continue to experience occupancy erosion, against a backdrop threat of a challenging second and third quarter, there is a propensity to drop rates in order to secure market share and just get heads in beds.  The inherent dangers of this are three fold.  First, any competitive advantage gained from rate decreases is most likely short-term.  The pricing strategy is easily copied by competitors and the end result is an overall market with depressed rates.  In most cases, a reduction in rates will not induce a significant amount of demand that does not already exist in a market, and it becomes a Prisoner’s Dilemma whereby if each hotel had resisted decreases initially, the whole market would have been better off.  Second, a decrease in rates requires a far greater increase in demand in order to break even.  The following table illustrates a simple example of this:

Assuming that fixed costs, variable cost per occupied room and the target NOI remains the same, a 10% decrease in rates implies a required 18.2% increase in demand in order to break even.  This becomes more pronounced the greater the rate decrease and it does not take into account the property wear and tear implications of a higher occupancy.  This example is basic, however it clearly illustrates the point that a quick-fix drop in rates requires a significant increase in demand to make up the difference to the bottom line. 

Third, the long term effect of significant discounting is the difficulty in growing rates back in future years.  A recent example of this would be the Downtown Toronto market during the SARS period in 2003.  This crisis lead to unprecedented rate decreases from $162.03 in 2002 down $144.01 in 2003, representing an 11.1% drop in ADR.  It took the market until 2006 to recover to 2002 levels.

Does this mean that discounting is completely ineffective and should always be avoided?  Not necessarily.  It’s unrealistic to think that there will be no discounting given the current market dynamics and the gravity of the economic slowdown.  However, overt discounts across the board will not achieve the desired effect.  The concept of discounting is based on the principle that in reducing rates, additional customers not currently in the market will enter the market and more rooms will be sold.  This becomes a question of whether one can lower rates enough to have a material impact on demand.  This is not generally the case.  However, in certain segments, targeted rate decreases can induce demand and not affect the rate integrity or positioning of the hotel.  An example of this would be selective discounting through opaque channels (i.e. Priceline, Hotwire). In addition, a focus on value added bundling (i.e. F&B vouchers, Entertainment, etc), rate differentiation, and rate fencing are all examples of tactics that help to reduce large decreases in average daily rates and maintain rate integrity.

First quarter results for the Canadian market show some interesting behaviour in pricing strategies.  Nationally, Q1 showed a 7.9% decrease in RevPAR over Q1 2008.  This was a factor of a 6.7% decrease in occupancy and a 1.2% decrease in ADR.   However, on a regional level, both Western Canada and Atlantic Canada posted a decrease in occupancy greater than Central Canada at 6.5% and 8.7%, respectively, yet Western Canada and Atlantic Canada both avoided any decrease in ADR while Central Canada posted a 2.7% decrease in ADR.  Preliminary data would suggest this may be worse in Q2.

The following table summarizes the relative changes in Occupancy/ADR for Q1 2009.

Based upon what we know or imagine about this market, we may be in for a protracted period of weak to mediocre results.  Ultimately, the tactics employed by operators in the short term will determine profitability and positioning of the property for years to come.  While the pressures to reduce rates are extraordinary, operators will benefit from comprehensive rate strategies that give careful consideration to the dangers inherent in overt discounting practices.

 

Tyler MacDonald, Consultant
PKF Consulting Inc. Toronto