The economics behind hotel loyalty programs (with insights from a former Marriott VP)

In the past, I've reported on how loyalty programs are becoming even more important to airlines during the coronavirus pandemic. But after a discussion with Jeff Borman — the former VP of Revenue Management at both Marriott and Hilton — I've come to realize that it's even more important to hotel groups. After all, in Borman's own words: "Hotels own customers, not real estate."

But there's more to it than just this statement. Hotels rely on franchises to make money, and their franchisees rely on the hotel group's brands and loyalty programs to bring guests through the door. In this article, I'll walk you through my conversation with Borman and other tidbits on how hotel loyalty works and just how it makes hotel companies hundreds of millions of dollars every single year.

I'll start with an overview of the hotel group business strategy — it's important to understand this as it has a huge impact on how loyalty programs make money. Then, I'll move into some key points on how loyalty programs generate revenue and how they work from a financial perspective.

Let's dive in!

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An introduction to hotel franchising

Hotels have a unique business model. In essence, these companies sell a set of familiar brands to both travelers and property investors. When a property investor buys land and wants to build a hotel, they may turn to a major hotel group to brand the property with a specific hotel property.

For example, say you just bought a building in downtown Manhattan and want to turn it into a new hotel. Instead of developing your own brand, you can sign a franchising contract with Marriott and brand your new hotel as a Renaissance Hotel. Here's a quick look at how this works, why a hotel would choose to go this route and how it plays into its bottom line.

Most major hotel companies don't actually own most of their hotels

Franchising is how almost all hotel groups expand their footprints. In fact, most major hotel chains have outsourced most of their properties to franchisees. We saw this trend start in the 1950s when Howard Johnson and Holiday Inn started the franchise model for its budget-focused hotels, and the rest of the industry followed suit over the coming decades.

Nowadays, the New York Times notes that data from FRANdata shows that 93% of all U.S. hotels were franchises in 2018. It's a worldwide trend too — while less prevalent than the U.S., many major hotel chains are moving to franchise in Europe. In fact, the majority of Choice, Wyndham, IHG and Hilton properties in Europe are franchises, according to Hospitality Net.

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Now you can see where Borman's "Hotels own customers, not real estate" slogan comes into play. Hotels can have other businesses do the heavy lifting of actually building new hotels. Then, they can send their loyal customer base to these hotels.

Related: How to pick the right hotel chain for you

Franchisees pay hotel groups huge sums of money

But if hotel companies don't actually own most of their properties, how do they actually make money? Simple: their franchisees pay huge fees every year. The initial franchise fee for a Hilton Garden Inn property is $75,000 plus $400 for each room over 150. This is a huge chunk of money for Hilton upfront.

But the money train doesn't stop there. There are ongoing fees that Hilton charges each of its franchises each month. Using the Hilton Garden Inn example above, the hotel charges 5.5% of gross room revenue as a Monthy Royalty Fee and 4% of gross room revenue as a Monthly Program fee. This means the hotel owner coild pay Hilton nearly 10% of its monthly revenue just to use the Hilton brand.

Plus, there are fees for training employees and commissions payable when a customer books after clicking on a sponsored link. The latter is a 4.25% commission for the Hilton Garden Inn brand. Hilton calls this fee the "EDGE Program" and justifies the cost because it pays "major search engines, ad networks, and direct referral partners to place listings in 'sponsored search' results and other online channels."

If you're interested, you can view the full 2019 Hilton Garden Inn fee structure on this Franchise Disclosure Document published by Hilton.

Related: The award traveler’s guide to Hilton Honors

This is how hotel groups actually make money from loyalty

Now that you know how the hotel franchising system works, here's how loyalty plays into the hotel revenue picture. When I sat down with Jeff Borman, my first question was simple: how much of hotel revenue is actually based on loyalty programs? He told me a number that way overshot my expectations: "it's close to 50% for the major brands."

Wow.

How can this be? Here's a look at the points Borman walked me through.

Loyalty programs build a franchise network

As discussed in the last section, hotel groups take a sizeable chunk of a franchised hotel's revenue. So, why exactly would a hotel owner pay this? Simply put: they're paying for customers.

Borman states, "The proposition to the owner is that by choosing a hotel with a powerful brand like Hampton, Courtyard, Holiday Inn or Ritz-Carlton, the brand will deliver a higher ROI to the investor or owner. The primary way the brand delivers that is with better occupancy."

According to Borman, this higher occupancy is possible because hotels "have an ever-expanding group of loyal travelers" who will only consider properties branded by their preferred hotels. This loyalty creates revenue for the hotel group and encourages a specific property owner to build more hotels within the brand elsewhere. In turn, this means even more revenue for the hotel group.

This all makes perfect sense. Think about it: how many times have you paid more to stay at your favorite hotel brand instead of an independent hotel nearby? Business travelers may have a corporate contract for better rates, so they're instructed to stay at a certain brand. Likewise, leisure travelers may have points from a hotel credit card they want to use to pay for their next stay. This isn't even taking into account points-earning and elite status incentives.

In short, the biggest way hotels make money from loyalty programs is by expanding their franchise footprint to make greater royalties.

Related: Are hotel brands getting out of hand?

Franchises pay hotels for loyalty points

Besides the fees discussed earlier, hotel franchises pay the hotel company every time someone stays at their hotel and earns points. According to the Franchise Disclosure document discussed in the last section, Hilton Garden Inn franchises pay Hilton a 3.6% (based on the guest's folio) every time someone stays at their hotel and earns points in the process. Further, Hilton charges $0.005 per Hilton Honors bonus point awarded for points awarded to event organizers.

We expect these numbers to be similar for other hotel franchises as well. At business-centric hotels with frequent travelers, this can generate a ton of extra cash for the hotel group as many travelers are earning points on business travel. Some of this fee is later paid out when points are redeemed (more on that soon), but it provides the hotel group with cash upfront, more loyalty and some profit as well.

Related: TPG picks hotels for business and leisure travelers

Credit card partnerships are a multi-faceted revenue generator

Like airlines, hotels also earn a pretty penny from cobrand credit card partnerships. Like airlines, hotel groups are paid based on the number of points they sell to the bank. The specifics aren't public, but the basic gist of these partnerships is that the issuing bank pays a set cash value to the hotel group for all of the points accrued by cardmembers.

In the case of Hilton, they make money every time you spend on your Hilton cobranded American Express card. Likewise, they make money whenever you transfer American Express Membership Rewards to Hilton Honors. American Express offers four Hilton credit cards, so this is a pretty huge revenue stream for the hotel company.

Interestingly enough, there are other benefits to these credit card partnerships too. Borman noted that hotels actually pay a lower transaction fee when customers pay with a cobranded credit card. This means more revenue for the franchised hotel and encourages said franchises to advertise cobranded credit cards on-site.

On top of this, these partnerships act as a form of insurance during travel downturns. We saw both Hilton and Marriott sell points in bulk to their travel partners during the coronavirus pandemic to raise much-needed cash. These sales are beneficial all-around: banks get cheap points and hotels get cash. And after all, what good is an insolvent cobrand partner to a bank?

Related: Chase, Amex spending millions on points and miles — what it means for the future of loyalty programs

The finance behind hotel redemptions

Another interesting topic we discussed was how hotel point redemptions actually work. More specifically, how does a hotel get paid when I redeem points for a free night? Further, how does this balance out on a hotel group's books?

Borman told me that hotels are split into two different categories: earners and burners. The earning side is mostly made up of business-centric hotels where many guests pay cash and earn points on their stay. Think hotels in the Financial District in New York City and The Loop in Chicago.

On the other hand, you have the burners. These are leisure-centric hotels in places like Time Square, Orlando and other tourist destinations. This is where people are more apt to redeem hotel points for family vacations and other personal travel.

As mentioned earlier, the earners pay a fee for the points earned on a guest's total bill. This money goes into a "pot" that is paid out when hotel points are redeemed. This money goes directly to the hotel where you redeemed your points, but the reimbursement amount can vary.

Borman noted that — in most cases — hotels are reimbursed based on occupancy. Hotels receive a reimbursement for the full daily rate during peak times because those rooms would likely sell out regardless. During off-peak times, these hotels may have vacancies, so the hotel group can get a far better deal and likely profit on the redemption. This is likely why we see peak and off-peak pricing for award nights with Marriott, IHG and others.

To put this into perspective, a 2018 One Mile at a Time article states that Marriott reimburses hotels with under 90% occupancy just slightly more than the cost of servicing a room. For example, the author notes that Marriott reimbursed the Marriott Kigali just $42 for a stay that cost 16,000 Marriott Bonvoy points. Currently, a night at the same hotel is $160 after taxes and fees.

Hotels have a competitive advantage over travel agencies

Borman said this reimbursement structure gives hotel loyalty programs a competitive advantage over third-party programs like Hotels.com Rewards. In the case of Hotels.com, you're awarded a free night after every 10 hotel nights you book with the company. The value of this free night is equal to the average cost of the past 10 hotel stays.

Hotels.com needs to pay the full amount of this certificate when redeemed. On the other hand, hotels pay based on a deal it worked out with its franchisees. If free nights are booked during low-demand days, the hotel can likely profit on this stay. On the other hand, it will generally break-even on more expensive stays.

Related: Ten Hilton properties I can’t wait to redeem Hilton Honors points for after the pandemic

Bottom line

All of this showed me that hotels are their loyalty programs. Since major hotel groups just own a suite of brands, they rely on loyalty programs and a good brand image to entice franchisees to open hotels under their brand names. In turn, hotel groups make money on royalties and loyalty program partnerships.

In my mind, this means that hotels need to continue to improve their loyalty programs to sustain themselves during the coronavirus pandemic and grow post-pandemic. During the pandemic, a good loyalty program will bring in loyalty through credit card partnerships and other partners. These hotels will then be able to grow post-pandemic with new hotel openings and higher travel demand once the pandemic subsides.

Feature photo by Felix Mizioznikov/Shutterstock