How Inflection Points in the Hotel Business Change Where You Lay Your Head
In 1977, James Eyster, then a Ph.D. student at Cornell, published a book that would completely change the nature of the hotel business worldwide. His idea could not sound more boring — unless you saw the impact it would have. It involved the negotiation and administration of hotel management contracts. Eyster’s groundbreaking insight was that by using a management contract — essentially an agreement for a hotel management company to act as the agent of a property owner — one could readily separate out the real estate part of the hotel business from the management part. In a textbook example of an inflection point, this insight had the effect of changing all the key metrics formerly used in much of the hotel business. My friend and colleague Ted Teng, the CEO of the Leading Hotels of the World, chatted about this with me as part of some research I was doing for my new book, Seeing Around Corners.
New Investors, Different Language
The effect on the sector of Eyster’s work was transformational. It opened up a whole new asset class for investment. It brought what Ted calls “novices” with funds to invest into the industry. It allowed hoteliers to get assets off their balance sheets, making their return on investment figures look more attractive. Whole new professions such as asset managers and hotel management companies sprang up. And the money came pouring in. New financial vehicles, such as hotel-specific Real Estate Investment Trusts (REIT’s) were created. In a breathtakingly short period of time, the dominant business model underlying the hotel business changed.
One consequence was to spur breakneck growth in the industry. For investors, having a new class of assets to invest in was attractive. For hotel management companies, the inflows of capital allowed the large brands to expand their presence, leading to significant growth in the whole sector.
It also, however, had the effect that inflection points often do, which is to change the key metrics that drive success. In the hotel business, a key metric that is associated with success is the occupancy rate of a property, where a good number is around 60% to 70% annually. People in the commercial real estate investing business, in contrast, talk about vacancy rates. It’s a different mindset. People in commercial real estate, for instance, sign 15-year leases where they are locked in on pricing. In a hotel, the price could be different every night!
In the early years of the inflection point, there were a lot of novice owners coming into the sector who really didn’t understand how things worked. And some of the operators took advantage of their inexperienced investors by negotiating really hard — and getting away with it. The Four Seasons, for instance, proudly noted in a 2005 SEC filing that its management contracts were exceptionally long, with new management contracts lasting some 60 to 80 years! Talk about patient investors…
As Teng recounted to me, he recognized that as investors gained experience and the category matured, this negotiating stance would not serve either party well over the long run. He would go so far as to assign potential owners Jim Eyster’s book to read, because “I’d like us to negotiate something that we won’t regret, that we are both happy with.” He recognized that the hard-nosed negotiating skills that may indeed be valuable in a more transactional setting could create a negative in the hotel management business. As he puts it, “With traditional sales, once you are done, you’re done. With a management contract, the negotiation is when your relationship starts!” He has seen many such relationships sour over negotiations that too heavily favored one side over the other.
As with so many other industries, the hotel business has been dramatically affected by digital. In the 60’s and 70’s, travelers found hotels by consulting guides, such as the American Automobile Association (AAA) guide, by asking hotels who were part of chains to book them into another property in the same chain (think Howard Johnson’s) or by calling a preferred hotel’s 800 number. In all of these cases, the information about hotel location, availability, rates, and features were all in the hands of professional salespeople. In those days, it was time-consuming and difficult for a consumer to comparison shop, and even travel agents had to call the same 800-numbers that the traveling public used. Pricing, similarly, was extremely stable — most hotels would print a rate card that was good for a whole year, rather than pricing dynamically.
The inflection point that changed this system dramatically started innocently enough in the 1950’s, when the first automated airline booking systems were created. Later, these systems added hotels. Called Global Distribution Systems (or GDS), these systems operated on terminals installed in travel agent and other professional’s offices. Built originally to sell airline seats, people began to explore the potential of these systems to sell other products — such as hotel rooms. This had the effect of creating an advantage for large chain operations that could have a booking code and an easy to record booking record. While it helped them sell rooms more easily — the travel agents could complete that process as they made other travel arrangements — it also had an unexpected side effect.
That shift was for firms using the platforms to essentially disintermediate themselves. The salesforce that used to be strongly aligned with one company became incentivized to sell for multiple properties. As Teng puts it, “You’re shifting from a company sales agent to a department store that would sell any hotels in the market.” While it was good for travel agents to have more choices, and it facilitated the ability to do some comparison shopping, it weakened the lock that individual brands had on their customers and began the kind of price comparison shopping that is the despair of the industry today.
Who Is Sitting in Front of the Screen?
The next inflection point was to shift the primary purchaser of a hotel product from travel agents to consumers themselves. The first glimmer of this as a commercial possibility was a direct-to-consumer booking product called eAAsySabre, an offshoot of American Airline’s SABRE system. It was one of the first GDS and launched in 1985. It ran over dial-up modems on the early Internet access system Prodigy. Primitive as it was by today’s standards, the system was a harbinger for what consumers would want from a booking system — ease of checking airline schedules and rates, ability to see hotel availability, and price comparisons, for example. But it was still very early in the development of internet commerce. Few travelers felt comfortable making actual purchases on the system. A 1989 New York Times article said that as of that year, only 150,000 people reserved or purchased tickets using their home computers. In a marvelous case of missing a pending inflection point, the Times opined that “travel agents have little to worry about.”
With the advent of the internet as we know it in the 90’s came the first startups that would signal the arrival of a really different way of doing business. Travelocity, an online Travel Agency (or OTA) launched in 1996. Expedia followed shortly thereafter, as did Priceline and a host of other sites that were agnostic as to whose travel experiences they offered. This development put all the information formerly curated by professionals directly in front of the consumer. This changed everything.
Consumers were now doing their own pricing research. They would tell their travel agents if they had seen lower prices online, which put the agents under tremendous pressure to get the lowest rates. Teng summarizes the shift: “The consumer is sitting in front of the screen at 3 a.m. in their underwear making decisions that professional sales agents once made. It was the biggest revolution in our industry — and nobody was asking the simple question, “Who is sitting in front of the screen?”
Incredibly quickly, the business of booking air travel went from essentially a Business to Business (B2B) model, in which travel providers offered information to professionals who use these tools all day long, to consumers who were novices, and for whom travel was often infrequent. Marketing became critical, and the greater pricing transparency the online systems offered led to well informed buyers who could now shop and compare their alternatives. The industry wasn’t ready — after years of enjoying pricing secrecy, this turn of events took many by surprise.
Not Your Dad’s Travel Experience
The biggest winners from this inflection point? Consumers, for sure, as they can now get more information and make more independent decisions than ever before. The biggest winners, however, were the Online Travel Agents. As Teng notes, they can “jump right in and hijack” the consumer before a travel provider even realizes that the buyer is in the market. Booking Holdings, the parent company of Priceline.com, Kayak.com, Opentable, and other online booking services enjoyed 2017 revenue of around $12.7 billion — revenue that formerly would have flowed to traditional hotel providers and the agents who performed the service. Expedia, likewise, earned 2018 revenue of $11.2 billion. Their growth is a result of getting on the right side of an inflection point. In contrast, Marriott International, the largest conventional hotel chain in the world, earned $22.9 billion in 2017 — and it actually provides services that the online travel agents just broker!
And Teng expects that the value of hotel operating companies may well decrease — the owners, who had been paying commissions to agents and management fees to management companies who brought them customers are likely to re-evaluate their spending. As the OTA companies rise, owners are highly likely to be reluctant to pay twice (once to the operating company and once to the referral agent). This puts pressure on the ability of the operator to earn their management fee. To some extent this is the price they are paying for having overlooked the dramatic inflection point that the internet represented to the travel business.
No One Will Pay to Stay in a Stranger’s Living Room — Or Will They?
Perhaps the biggest inflection point to hit the hotel industry, however, is that of a changing arena for hospitality entirely. As I have mentioned elsewhere, an arena view (as opposed to an industry view) of how one competes ignores traditional industry boundaries. Instead, what you want to focus on are customers, and what Clayton Christensen has famously called their “jobs to be done.” In other words, customers only buy from you incidentally to getting something they want to get accomplished done. They in effect “hire” products and services. And yet, wrapped up in the day-to-day of our own business, with decades of experience of what works and what doesn’t in our heads, it is very easy to be blindsided by an entirely new way that jobs can get done that divert revenue from the incumbents’ pockets to that of a newcomer. The online travel agents did it with online booking.
And a startup, Airbnb, founded in 2008, is in the process of rewriting the rules for the hotel and hospitality business. Like other digital platforms, including Uber, YouTube, and Facebook, Airbnb was initially dismissed by the incumbent players. The predominant wisdom, for both hotels and for Airbnb, was that they served different markets.
Since then, of course, Airbnb has become a dominant player in the lodging industry, taking advantage of the post-recession economic growth and of new “jobs” customers want to get done. Airbnb effectively taught an entire generation that travel didn’t have to involve cookie-cutter rooms without access to kitchen facilities or a place for a group to comfortably hang out. What it offered instead (in addition to lower prices for more space) was a sense of place, a smiling local host, cooking and washing facilities, and (hopefully) pleasant surprises to visitors looking for something different from the ordinary. And in cities in which hotel space is scarce or expensive (the original impetus for Airbnb’s founders to begin with) it offered an alternative option.
Hoteliers, initially somewhat asleep at the switch, have now started to wake up. Some are designing so-called “boutique apart-hotels” that combine the spaciousness and amenities of an Airbnb with the cleanliness and services of a hotel. Many are rethinking the designs of their spaces so that they can flexibly reconfigure them in light of changes in demand. And some are trying to lure back travelers by offering experiences that would be hard for a local host to match — such as sophisticated technologies that match preferences to offerings. Airbnb is, in short, facing a maturing market and increased competition.
The biggest existential threat for Airbnb, however, is likely to come from a much more traditional source of disintermediation in the hotel business — and that is the expansion of online travel agents’ listings to include private homes as well as hotels. Booking, for instance, noted in a recent filing that in addition to the 430,000 hotels, motels, and resorts it listed, it also offered approximately 1,635,000 homes, apartments, and other unique places to stay. From a customer point of view, searching on Booking will give you more options from a single point of entry than searching separately on an OTA site and then on the Airbnb site.
Airbnb faces other headwinds as well. As more people get familiar with the idea of private home rentals, the practice stops seeming exotic. As the company gets larger, unpleasant incidences, poor reviews, and issues regarding privacy and safety become more common and are quickly magnified by social media. There is even a website called AirbnbHell.com that is dedicated to guests’ horror stories. Ensuring quality and a consistent experience, which hotels have learned to do over the course of many decades, is hard to do when your workforce is distributed, they don’t actually work for you, and you have very few enforcement mechanisms.
The question is thus whether Airbnb’s advantages as a platform will be sustainable, or will we see it erode as the line between booking behavior for a hotel and booking behavior for a private home (or some hybrid thereof) blurs. I have to say that my bet is that the OTA platforms will eat up an increasing amount of people’s attention because it’s just easier. Never underestimate the importance of jobs-to-be-done.