China's Economy Hotel Business: Is It Too Hot?

Home Inns, an economy hotel chain headquartered in Beijing, went public on the NASDAQ on October 26th, 2006. Less than two months later, Jin Jiang International (Group) Co., the Shanghai-based corporation focused on travel business in China, followed suit in Shanghai and Hong Kong, announcing that the major part of its financing would be used for the expansion of its economy hotel subsidiary Jin Jiang Inns.

Home Inns opened its first hotel in May 2002, and only five years later, it has become a nationwide behemoth running 82 hotels and raised more than $100 million from the stock market. “Every hotel [in the Home Inns chain] had reached a market value of RMB 43 million (about $5.3 million) by the time it went public, while the cost of each was only RMB 5 million ($600,000), 8.6 times the original investment. This is an impossible achievement for traditional hotels,” said Hu Shengyang, CEO of Shanghai Inntie Hotel Management Consulting, a company that provides consulting and training services for economy hotels. 

An economy hotel, called a “bed & breakfast” hotel in Western countries, offers standardized hotel services with a better price/performance ratio than luxury hotels, because it keeps only a high-standard accommodation facility. It has no accessory facilities for meetings, entertainment and catering, and cuts down on procurement costs and staff through standardized brand operation and facility management.

According to the development plan of Jin Jiang International Group, Jin Jiang Inns will increase its number of economy hotels from 165 (the number it had at the time of its IPO) to 600 across the country by the year 2010. Home Inns is also running full throttle. Its finance report shows that 27 more hotels were set up in the fourth quarter of 2006 and another 48 were under preparation. Sun Jian, CEO of Home Inns, said that they would hit a growth rate of 60% to 70% in the number of hotels in 2007.

 

Besides these two listed companies, other unlisted economy hotel chains -- including Motel 168, GreenTree Inn Hotel, 7days Inn and Hanting Inns – are also expanding quickly. For example, 7days Inn, a hotel chain that sprang up in south China, has opened 29 hotels and has another 53 on schedule following an investment of $10 million from Warburg Pincus last October. It plans to open at least 100 more this year. 

Hanting Hotels, a middle-end business hotel chain started by Ji Qi, one of the founders of Home Inns, opened 20 hotels and has another 30 to 40 planned. This year it launched its subsidiary economy hotel brand, Hanting Inns, and its overseas listing is underway. Another business hotel chain, GreenTree Inn Hotel, plans to reach a goal of 225 hotels this year and 500 hotels by 2008 after getting an additional investment of $70 million from American Pacific Home(APH).. And Motel 168, a Shanghai-based economy hotel chain that recently received a large investment from Morgan Stanley, has its public listing well under the way. In addition to these local players, international hotel management groups, including Ibis from France and Super8 from the U.S., have made substantial forays into China’s economy hotel market.

Wave upon wave of investment, from overseas private equity funds to state-owned capital to domestic private capital, are pouring into this booming market, further stimulating its rapid expansion.

Signs of Overheating

 

Various economy hotels can be found every 50 meters on a less-than-200–meter street in neighborhoods near the centers of  Beijing and Shanghai. Is there really such a huge demand for economy hotels in China?

Zhang Minghou, assistant to the chairman of the China Hotel Association, a non-profit trade organization, tells China Knowledge@Wharton that “Economy hotels have doubled every year in the last two years in the number of both brands and rooms.” Zhang believes that this expansion frenzy will make a rational adjustment before long. According to the April 25 Analysis Report of China’s Economy Hotels 2007, published by the organization,  2006 has seen a 7% fall in occupancy rates of economy hotels -- from 89% in 2005 to 82.4% last year. Meanwhile, the average room rate has dropped from RMB328 ($41) in 2005 to RMB209 ($26) in 2006.

 

“Currently, many investors and hotel managers still expect a near-9-times-their- investment return, as in the case of Home Inns’ public listing. But good days are gone. Two years ago, a single hotel was capable of giving an annual return of more than 30%, even as high as 50%. But now it has fallen to around 20%-30%,” says Hu Shengyang from Inntie Consulting.

Home Inns’ recent finance report shows an occupancy rate of 90% in the fourth quarter of 2006, a slight drop from the 91% rate of the same period in 2005 and the 94% rate of the third quarter in 2006. Its average room rate has fallen from RMB 172 ($20.7) in the third quarter to RMB 165 ($19.9) in the fourth quarter. The report attributes the quarterly decrease in occupancy rates and room rates to the opening of 27 new hotels in the fourth quarter. Last December, Merrill Lynch, one of its underwriters, downgraded its rating from “buy” to “neutral”.

“Although we haven’t seen the breakout of a price war yet, we do smell its smoke in the air,” says Hu Jianwei, marketing director of GreenTree Inn Hotel, which opened its first hotel in Shanghai in November 2004.

Home Inns’ CEO Sun Jian admitted during a recent press conference that there is a bubble in the market. He warned that, in spite of huge market potential, the belief among many peole that economy hotels mean high profits is simply too optimistic. Blind investment without market analysis may lead to a high risk, he says, adding that there’s still lots of room for latecomers in a market where demand is great but fully integrated brands are scarce.

Property Costs Keep Rising

Before 2006, the payback period for investment in a single economy hotel usually ranged from three to five years, but now it has been lengthened. Insiders unanimously believe that the rise in the cost of hotel property contributes the most to the drop in profit return. The property issue has become a decisive factor in whether a hotel can generate a profit or not.

Top Star Hotel, founded in Shanghai in 2005, announced at a recent press conference that it would “accomplish in eight years what American companies have accomplished in 40 years.” It has 17 hotels currently, and plans to open as many as 120 hotels by the end of next year, 200 by the end of 2009 and 1,000 across the world by 2015. According to its blueprint, it will have 180,000 rooms by then and will rank in the top three  domestically and the top five internationally. This project needs an investment of RMB 4 billion ($480 million), one reason the company plans to go public in 2008.

This kind of hectic investment and expansion is contributing to the rise of already high property costs in China. Zhu Yi, an analyst at Chang Jiang Securities, recently told a local reporter that “blind investment and disorderly competition will lead to an overall rise in the price of commercial real estate and potential economy hotel properties, which will put huge cost pressure on those economy hotels.”

A manager from an economy hotel responsible for property development told China Knowledge@Wharton that a property owner in Xi’an, while negotiating with them, had arranged meetings with another two clients on the very same day. It is reported that some owners of spare properties often get one call after another from various economy hotels.

According to Hu Shengyang, “Within the inner ring road of Shanghai, the cost of renting an old workshop into an economy hotel has increased from RMB 0.5 ($0.06) psm (per square meter) two years ago to the current RMB 2.5 to 3 ($0.3-0.36) psm. Nowadays most properties are leased through open bidding, which means getting low-rent properties is no longer an easy job.”

Low-cost property doesn’t guarantee the successful running of hotels, but high-cost property does make it very hard to generate a profit. The result is the irony that property renting has become the core competence in this business, while management talent and investment -- two things valued more by other industries -- have fallen behind.

According to statistics from the China Hotel Association, the property cost of economy hotels in 2007 has increased more than 40% compared to last year. “Lots of hotels are signing expensive contracts to maintain their fast expansion. Once the whole industry enters into a price war, it’s predictable that many of them will go bankrupt or be acquired by stronger players,” says Zhang Minghou.

Market Potential Still Huge

Hu Jianwei notes that “one of the GreenTree hotels in the neighborhood of Jing’an Temple, Shanghai [one of the busiest streets in Shanghai], used to record an occupancy rate of 102%, which means that some rooms were taken twice in one day.” Hu Shengyang added that there is an explosive demand for economy hotels in the market which the existing ones can’t meet. “It is a whole new idea for many people.”

Despite some apprehensions, Zhang Minghou is optimistic about the long-term development of this industry. “The drop in occupancy rates this year tells us it’s time for some regional adjustment. But I still expect there’s huge potential yet to be unlocked in a market as new as economy hotels. We just have to get back down to earth and be rational.” The CRA report shows that there are nearly 1,000 economy hotels in China, providing a total of 100,000 rooms, and it predicts a market 10 times larger than the existing one.

The U.S. has around 60,000 economy hotels, accounting for 75% of its entire hotel industry. Economy hotels in China, with an average occupancy rate over 80%, accounts for only 10% of the whole domestic market.

Angela Feng, manager of supplier management & procurement at American Express Business Travel, predicts that “a transition from material consumption to experience consumption will take place in China as its economic boom continues and Chinese people have more money to spare. “Since travel is a major form of experience consumption, she told China Knowledge@Wharton, “we have every reason to expect the hotel industry will grow bigger and bigger. Furthermore, Chinese tourists are not especially picky in hotels and care mostly for the basic facilities and services, which are just what economy hotels promise to offer. Hotels with trustworthy brands, good locations and attractive prices are bound to flourish.”

The Way Out

China’s Economy Hotel Encyclopedia, publicized by www.1rest.com, a website providing real-time economy hotel reservation services, shows that there are currently 142 economy hotel brands of different sizes in China, all of which are run with undifferentiated strategies. In interviews, most hotel managers and experts considered differentiated competition and development in small-and-medium cities to be the two ways out for China’s economy hotels.

Pioneers are already in action. It’s reported that Home Inns has carried out preliminary site selection in Lanzhou, a city in west China, planning to open 10 hotels there in 2007 and four more in 2008. Jin Jiang Inns is also going to set up two hotels in Lanzhou, one regular and the other a franchise operation.

“However, the cost of opening an economy hotel in a small and medium city is likely to exceed that in a big city,” warns Hu Shengyang, “It’s hard for nationwide hotel chains to compete with local hotels for inexpensive properties. And the cost of staff recruitment and training is much higher there. Opening a hotel in Chengdu may cost you two and half times as much as opening one in Shanghai.”

In the meantime, quite a few hotels, in an attempt to jump out of the homogeneity swamp, present themselves as theme hotels. For example, Scholars Inn Theme Chain Hotel in Suzhou creates an atmosphere redolent of ancient private Suzhou-styled accommodations, with classical furniture of the Ming and Qing Dynasty styles and more than 1,000 books in each of its four hotels. Likewise, hotels focused on sports, travel, love, cartoons and folk customs are ready to attract customers with different tastes.

Zhang Minghou believes that the key to success is to have a differentiated positioning strategy that avoids homogeneity and explores unexplored niches. He also notes that the “current competition is focused on hotels with room rates from RMB 100 to 200 ($12-24). If any company could explore the sub-100 market, it would be very competitive.”

This opinion is echoed by Angela Feng, who doesn’t think China’s economy hotel is economical enough compared to its American counterparts in terms of the ratio between the room rate and the average income of people. “No more than 100 yuan. That’s what real economy hotels should be in China,” she says.


Published : 2007.05.09



 

















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