Essec Business School

The theory of transaction cost economics (TCE) teaches us that the more adaptable an asset is, the higher the price it can fetch. If someone buys an asset that has been developed for a particular need, they then have to adapt or customize it for whatever new use they have in mind. Since this involves cost for them, they are less willing to pay a higher price for it. But if the asset is ‘ready to wear’, and does not need to be tailored to their needs, they will be happy to pay more to acquire it.

With their research “The discount effect of non-normative physical characteristics on the price of lodging properties” ESSEC Management Professor Nicolas Graf and co-author Ines Blal of the École Hôtelière in Lausanne wanted to test this theory in the context of hotel buildings. Indeed, over the last 30 years, hotels (or ‘lodging properties’) have emerged as one of the key types of real estate, alongside retail, office, residential and industrial properties. By 2007, the market for lodging property had already reached $122bn in transaction values, and it bounced back strongly from the global financial crash.

The reasons for such a growth might include: the fact that other investments are performing poorly; real-estate investors are more sophisticated, and there are more numerous; and large hotel groups are less interested in owning their own buildings. As the business of running hotels becomes separate from the ownership of the ‘bricks and mortar’ behind them, investors are looking for ways to standardize hotels’ key physical characteristics, and make it easier to value and trade them in a simple, transparent way.

Analyzing some 10,722 transactions – and using two types of statistical modelling to measure deviation from the norm – Graf and Blal focused on the physical characteristics of hotel properties and in particular the number of rooms, the number of food & beverage outlets (F&Bs) and the available meeting space, in square feet. Three hypotheses were developed and tested to explain the links between physical asset specificity and market discounts in the hotel real estate:

1. The further a hotel’s physical attributes deviate from the norm, the larger the discount on its selling price.

Graf and Blal argue that a standard or norm for hotels’ specification has emerged. Properties with specifications that are close to this norm are easier to buy and sell, because they can be more easily rebranded and reused by a different hotel chain. In economic language, they are liquid assets with low specificity. Conversely, more unusual properties with non-standard characteristics are less in demand, so they are likely to take longer to sell, and their prices will probably be discounted too. Assets like this are said to be illiquid, with high asset specificity.

However, liquidity is a concept that cannot be measured directly and one must choose a proxy measure that reflects it. In this study, the researchers chose price discounts and reflected it in asset specificity, which can have several dimensions such as location, physical characteristics, brand name capital and time. The study stayed focused on physical attributes since they are the most important when it comes to selling a hotel, and have a direct influence on its market value.

This first hypothesis was fully supported by the findings: the further individual hotels deviated from the norm (whether in terms of the number of rooms, the number of F&Bs or the amount of meeting space) the larger the discount applied to their prices on the market.

Interestingly, this rule applies in both directions. The price will be discounted whether the hotel has too few rooms relative to the norm or too many. The same applies to F&Bs and meeting space. In other words, it is possible for a hotel to be ‘too good’ or ‘too differentiated’ for its price bracket.

2. The physical attributes contributing to a hotel’s asset specificity vary across industry segments

Since hotels vary widely in terms of service level (economy or luxury) and consumer profile (leisure traveller or business person) and liquidity can only be measure when talking about a single asset type, Graf and Blal sought out to argue that hotel asset specificity varies across industry segments. In other words, depending on the hotel type, different physical characteristics might be more or less important to a buyer.

Findings, however, only partly supported this hypothesis: Most variables are not equally significant for every segment of the hotel industry. That said, the number of rooms was a constant factor: it is significant regardless of the type of hotel.

3. There are more factors affecting the norm in upper segments than in lower segments

To reflect segments within the hotel industry, Graf and Blal developed four categories based on US industry standards: luxury, upscale, midscale and economy. These reflected the level of investment in the physical attributes of a hotel, from highest to lowest. Through this analysis, they argue that the more that has been invested in developing properties in a segment, the more physical attributes are involved in determining the norm in that segment.

While the study’s findings did not support this hypothesis, they were none-the-less interesting to note. Indeed, data showed that the upscale segment (the second ‘highest’) used a norm based on all three of our physical attributes of choice. The norm of the midscale segment, on the other hand, focuses purely on meeting space – and, since the norm is to have no meeting space at all, hotels that do have it are traded at a discount.

In both the luxury and economy segments, the number of rooms is the significant measure, but for different reasons. In the luxury segment, it is because properties are more likely to be ‘exceptional’ hotels with unique features, making conformance to a norm less important. In the economy segment, it is because hotels must simply achieve minimum standards rather than conforming to an ideal type.

This study helps to validate the link between asset specificity and price as a reflection of liquidity, which previous researchers have assumed. More importantly, it points the way forward to future research into why norms are less important in pricing luxury and economy hotels, as opposed to those ‘stuck in the middle’. On a practical level, this research can also help real estate investors assess whether it is worth paying a premium for a hotel, and help operators work out whether investing in improving the physical attributes of a hotel will increase or decrease its market value.

“The discount effect of non-normative physical characteristics on the price of lodging properties”, published in The International Journal of Hospitality Management.