The financial crisis that sent shock waves through out Asia has left no industry untouched in the last year. The hotel industry, whose fortunes typically track the general economy is no exception. Since the first signs of crisis in the Thai  Baht devaluation on July 1997, on July 1997, room  occupancies have plummeted in many hotel markets. Individual hotels that maintained strong occupancy have generally done so by reducing room rates. Inevitably, price wars have affected the competitive dynamics in the marketplace. In China, for example, five-star hotels have adjusted prices to levels directly competitive with mid-market properties. Occupancies in Hong Kong during the third quarter of 1998 were estimated at 70 percent-a level achieved only through room  rate reductions of up to 40 percent in some cases. 

The challenges facing hotel companies in Asia-Pacific raise questions for the hospitality industry throughout the region. To gain knowledge and insight, Arthur Andersen embarked on a study of senior executives working in Asia-Pacific. Our goal was to answer three pressing questions. 

• What is the current and likely future impact of the economic turmoil on the hotel industry in the region? 
• What characteristics does the current hotel investment environment show? 
• And what are the strategies being contemplated to weather this Storm? 

The Research - Scope and Methodology 

Our study was based on a questionnaire mailed to 640 hospitality industry executives in Asia-Pacific in September 1998. The basic questionnaire was tailored to three constituencies in the industry-hotel owners, financial investors and management companies. We were particularly interested in determining whether there were any significant differences among the three groups of respondents regarding the interpretation and resolution of the current economic environment. A total of 141 completed questionnaires were received, a response rate of 22 percent. 

Hotel Demand Plummets 

The Asia-Pacific hotel industry serves a complex mix of regional and international business and leisure travelers. Many hotel products and destinations, however, are highly dependent on Asian customers, primarily from Japan and Korea. 

W hen these two countries stumbled economically demand began to fall across all hotel market segments in Asia -Pacific in the first three -quarters of  1998, compared to 1997. One of the exceptions is Thailand where tourism arrivals have been up by more than 6 percent.  This downward pressure in demand has also affected many of the regional carriers, such as Cathay Pacific, which for the first time in its history reported an operating loss. The decline in Japanese outbound travelers to Hong Kong was the primary cause. Japanese tourists and business executives have in many cases accounted for 30 percent of occupancy at Hong Kong luxury hotels. Almost overnight, this demand has been reduced to near zero. 

As a result, we wanted to assess leadership's views on changing demand and risk in the hotel industry. Few executives put a positive light on these questions. Nor did we find significant differences of opinion among hotel owners, investors and management. The majority of executives believe that demand for hotel accommodation will continue to be either moderately or severely affected by the financial crisis. Almost 80 percent of all respondents thought that demand will decrease to some degree in four travel segments: 

• the business-individual traveler, 
• leisure-individual traveler, 
• corporate meeting 
• and incentive meeting. 

We also asked these executives to assess the impact of the regional crisis by comparing four hotel products: city business hotels and resorts, and luxury business hotels and mid-market properties. Surprisingly, respondents believe that city business hotels wilt not be impacted more severely than resorts. This is in direct contradiction to speculation by industry observers and commentators. These executives appear to think that the destination, location and demand patterns of the hotel product will be the key determinants of how much a business is affected by the region's economic problems - not the type of customers it attracts. 

Interestingly and not surprisingly, nearly 60 percent of the respondents believe that the luxury hotel market will be harder hit than the mid-market hotels. As demand has plummeted in many markets, we have recently seen how five-star hotels openly compete with the four-star market to gain lost occupancy. But there can be consequences to pay. The luxury hotels have higher cost structures. While they can reduce their room rates temporarily, such strategies can exacerbate the impact on bottom line margins. This is especially true for those five-star properties that do not adjust their operating cost structure accordingly. 

Leadership Agrees - Reduce Operating Costs 

Executives in Asia-Pacific hospitality face a disturbing dilemma. How can they maintain profitability during these prolonged economic downturns? Some owners of hotel properties are facing significant devaluation in market value, cash flow shortages and an increase in US$ denominated loan balances. Many hotels in Thailand. for instance, are literally bankrupt and have failed to pay interest to their lenders. On the other hand, lenders have little legal power to foreclose on such under-performing assets. 

Given this bleak situation in many parts of the region, we asked the executives surveyed in this study whether they believe that "cutting operating cost is the best strategy to maintain profits during downturns." More than 50 percent of the hotel owners and management executives agreed or strongly agreed that this is the case. A portion of  respondents, however, were sharply divided on this question. Almost 30 percent of management executives disagreed that cutting operating costs is the best strategy, compared to only 10 percent of hotel owners. 

Hotel owners and management can implement cost cutting in diverse ways. We asked these executives how they would go about reducing operating cost. Both hotel owners and management ranked payroll and labour-related costs as their first choice. Owners ranked capital expenditures (Capex) as the second area to cut. In contrast, hotel management companies ranked utilities and other energy costs as their second choice. Capex was rarely cited by hotel management executives, who indicated instead that they would prefer to focus first on cutting costs in the Admin & General department. The general agreement among owners and management on the importance of reducing operating cost, however, is certainly positive given the urgent problems facing many properties. But reducing costs without jeopardizing the revenue line is not an easy task. Careful studying of internal processes and the effect of reducing costs on the ultimate impact on hotel guests is required. 

Show Me the Money... 

In the years prior to the current financial crisis, the hospitality industry was enjoying a period of growth that was without precedent in the region. The continuous availability of low-cost funds fueled a pipeline of hotel transactions and development activities. As financial turmoil began to topple economies, many hotel projects underway across the region were suspended. while developments on the drawing boards were mothballed. Few hotel properties are currently being considered for development anywhere in the region. For example, the Westin and Grand Hyatt in Kuala Lumpur, both of which are already out of the ground, have now been suspended for at least two to three years. 

Given these market problems. it is not surprising that more than 80 percent of the executives polled in this study indicated that the current availability of both debt and equity capital for hotel investments is significantly worse than one year ago. Notably, debt capital was considered to be even less available than equity capital. Banks lending in the region are carrying a substantial ratio of under-performing loans on their books and often have little legal power to foreclose and sell be assets at fair market value. As a result, the lending situation is unlikely to change any time soon. However, countries such as Thailand are taking strides to push through new laws dealing with these exact issues, as they have come to recognize that this is stalling the recovery process and keeping foreign investors at home. 

As to how quickly the situation might turn around for the better in Asia-Pacific, there seems to be no significant difference in opinion among the hotel owners, investors and management.  Viewed from a wider perspective, nearly 40 percent of the total respondents believe that the hotel industry in Asia might recover within two years. Another 40 percent believe that the hotel industry in Asia will recover within tree years -  with the balance of executives polled being more pessimistic. 

It is our conviction that different Asian hotel markets will recover from their domestic problems at different rates, depending on the government's willingness to act and the ability to re-establish confidence in the domestic markets and economy. Countries such as Thailand and South Korea have already taken, in our opinion.. many of the right steps forward, which will see them recover more quickly than countries such as Indonesia or Japan. The Japanese banking system is severely burdened by under-performing real estate loans, a problem of immense scope arising from over-valuation of markets. Real estate loans are currently being sold off by the hundreds of millions of dollars (US$) to begin the process of remedying the situation. The Hong Kong SAR government's intervention in the stock market, although controversial, has managed to bring back confidence although tourism figures have not shown a similar pace of recovery. Nor has the new airport, which had a disastrous opening. induced any new air carrier and tourist demand. 

Is the hotel business a good real estate business to invest in when it comes to cash flow? About 45 percent of hotel investors agreed that hotels offered the fastest turnaround in terms of cash flow when compared with residential, office and retail real estate. But opinions were split. More than 40 percent disagreed. Hotel owners are divided right down the middle with 35 percent agreeing and 35 percent disagreeing on this question. Roughly 80 percent of hotel investors and owners agreed that the anticipated financial performances, primarily, and the economic conditions secondarily, will be the most important factor influencing their capital investment. It is notable that hotel investors gave a 10  percent higher rating to the general economic conditions, whereas hotel owners ranked the availability of capital higher by a similar margin. 

The unfavourable investment environment has clearly threatened the appetite of hotel developers and investors, delaying many hotel transactions. Investors, particularly from Europe and the United States, are interested in attractive buying opportunities, but remain cautious about any development prospects. Of the executives surveyed, more than 60 percent of the hotel owners believe that hotels present good value buying opportunities at 40-50 percent below a realistic price level relative to replacement costs. Investors have a slightly different perspective with 48 percent also believing that hotels present good value buying opportunities at 40-50 percent below a realistic price level relative to replacement costs. A further one-third of investors, however, believe that at 20-30 percent of below replacement cost, there is already a good value buying opportunity. 

This expectation of potential buyers, however, does not meet the current seller's expectation. A large gap remains in what hotels would be considered a good buy, which in some cases represents 10-25 percent of the acquisition value. Places such as Phuket and Samui in Thailand have recently seen significant improvement in performance, while the real estate market has declined as a result of the devaluation. Coming to an agreement on a basis for acquisition values will be especially difficult in these markets. More often than not, Thai hotel real estate has been valued as a fixed asset rather than on a "going concern"  basis using the method of discounted cash flow. Increased lending spurred additional development and then further rounds of lending, which were backed up by rising real estate values. This vicious cycle suddenly came to a halt in the last year. Gaps in value perception, however, are unlikely to be overcome in those countries where bankruptcy and foreclosure laws are non-existent or impossible to enforce. Only if the ultimate holding company or owner needs to urgently divest property for other company purposes will transactions likely occur. Otherwise, owners will weather the storm. 

This scenario is becoming ever more likely as owners ride out the economic crisis by keeping their lenders, who have often much to lose, and possibly their co-investors, at bay. Selling properties when the worst is over and the market turns might work in many countries as long as the hotels generate enough cash flow to weather regional economic shocks. To do this they will need to cover wages and management fees, minimizing capital expenditure. 

International management companies. however, will also find themselves under intense pressure from owners to achieve "more with less." Conflicts over what constitutes the business's core objective will be inevitable. One example is the reduction in Capex, which hotel owners answering the survey said they favoured. International managers will find this hard to swallow as they endeavour to maintain market share and drive operating profits. 

How and Where to Grow in These Challenging Times 

Owners, investors and management companies will have to adapt to this quickly changing and dynamic economic environment. As in other recessions, the events in Asia-Pacific also represent opportunities for some aggressive companies. We asked the management companies to rank the importance of various growth strategies in terms of their expansion. About 46 percent of the respondents favour management contracts as a strategy for expansion, followed by mergers and acquisitions and strategic alliances. Joint ventures with local partners were not rated very favorably with less than 5 percent indicating such a strategy is suitable for growth in the current environment. In contrast, 44 percent of hotel owners agree or strongly agree that they are increasingly interested in franchising rather than management contracts. Franchising allows hotel owners to keep management control of their hotel properties, but enjoy the franchisor's reservation and marketing network for usually a fixed percentage fee of room revenue. 

As most of the management companies prefer management contracts as a growth strategy, fee structure will remain a major concern between owners and management companies. Seventy percent of these executives agree that a growing number of operators are willing to accept a fee structure based on profit performance. Hotel management fee structures have changed over the years as competition has been increasing and owners have come to understand the business better. Revenue based fees are nowadays anywhere between 1 and 5 percent with gross operating profit (GOP) based fees of 5-10 percent. More recently, management contracts have been signed which are only GOP or even NOI-based. We see this trend continuing in Asia. 

Customers today increasingly prefer branded hotels. Branding conveys a certain level of quality to customers. evokes expectations and reduces risks for customers traveling in many different parts of a country or the world. More than 80 percent of hotel investors and hotel management companies believe that business travelers will prefer branded products and services. In contrast, only 60 percent of these respondents believe the same holds true for leisure travelers. International brands have traditionally invested most of their resources in establishing themselves in key gateway cities in Asia-Pacific and have only in the past few years entered the resort markets after development opportunities ceased in major metropolitan areas. This also suggests that regionally managed and often smaller brands might be able to sustain their competitive advantage in delivering an authentic product true to its surroundings and genuine service for some time longer. International brands generally have less flexibility in adapting their product since their customer base tends to demand a certain level of product and service. 

Consolidation has been a powerful force in recent years as the hospitality industry has been reshaped by waves of mergers and acquisitions. A significant volume of mergers and acquisitions took place last year (most notably Bass' acquisition of Inter-Continental). And the executives surveyed in our study believe this trend will continue. More than 80 percent "agreed" or "strongly agreed" that we can expect more mergers and acquisitions in the hotel industry. 

Lastly, we asked all three groups of respondents to tell us about their choice of most desirable markets for city hotel and resort developments in Asia-Pacific. Not surprisingly, the outcome varied.  In order of priority among city hotel developments, the hotel investors polled cited Bangkok, Hong Kong and Sydney. Hotel management companies still saw room to expand their brand in Sydney, Shanghai, Manila and Singapore. Hotel owners favour Bangkok and Hong Kong, a market with traditionally high barriers to entry. Management companies see opportunity outside Southeast Asia, i.e. China and Australia, possibly due to the current supply-and-demand situation, and their existing coverage of key cities elsewhere. 

In terms of resort developments, all three respondent groups seem to agree that Phuket and Bali are locations where capital might be invested. In a distant third, the hotel investors cite The Maldives; hotel management companies also thought highly of Palau in Micronesia. 
 
 

Hotel owners, investors and management all share a common view that the economic turmoil of the Asia-Pacific region has cut deeply into the industry's strength, and left much of the region with little access to equity or debt capital. And markets, these executives believe, will not be on the upswing for some time to come. Nevertheless, there are rays of light, in part due to the wisdom and willingness to act aggressively in the face of the current circumstances among some governments and private industry. Certain resort destinations, especially in Thailand, have seen strong demand growth recently as their infrastructure allows for easy access of international leisure travelers who believe Asia is now a bargain. Governments also are feeling the pressure to act by making destinations more attractive, especially to tourists. Under consideration in some areas are new attractions and expanded marketing campaigns. The economic crisis that so quickly engulfed Asia-Pacific will produce winners and losers. By encouraging the hotel industry to get on a solid footing. the turmoil of the past year and a half will eventually have its benefits for hotel managers, owners, and investors-and, of course, for the business and leisure travelers it serves. 

(Andrew Flaig is a Manager in Arthur Andersen 's  Hospitality & Leisure Practice. He is based in Hong Kong.  Gloria Chang is a Senior Consultant who is also based in Hong Kong.) 

©Arthur Andersen