Industry Update
Opinion Article14 October 2019

Are investment decisions really independent? The role of decision making biases in hotel development projects

By Achim Schmitt, Associate Dean and Professor at Ecole hôtelière de Lausanne and Samrah AlShawi, Project Manager at the Ecole hôtelière de Lausanne

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Achim  SchmittAchim Schmitt
Samrah  AlShawiSamrah AlShawi

Think back to an important decision you have had to make. You may have weighed out the costs and benefits, studied the context, and evaluated the potential outcomes. While one hopes that careful analysis will lead to rational choices, the truth is that our human minds are complex. Our rational decisions are doctored by - amongst many others - feelings of potential regret, conscious or subconscious references, emotional attachment, and herd mentality. These biases prevail in business as much as they do in our personal lives, and we are all prone to them. We take a first look into the role of herd mentality in hotel investment decisions.

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"Location, location, location"

A bird's eye view of the US hotel market exposes the phenomenon of geographic clustering amongst hotels (see figure 1). In fact, concentrated hotel supply can lead to positive agglomeration effects on the destination's market size and infrastructure. However, hotels may miss out on these benefits as market saturation and fierce price competition can limit the property's RevPAR potential. Indeed, researchers and consultants alike agree that late market entry and followership in hot markets do not support the profitability of the individual business [1].

The prevalence of hotel market 'hot spots' therefore begs the question: do rational economic considerations rule, or are investors jumping on a bandwagon?

What exactly is herding behavior and why does it exist?

Behavioral decision theory tells us that all humans are boundedly rational and decision-makers rely on simple decision rules and other heuristics in order to deal with environmental complexity, dynamism, and uncertainty. In other words, when we cannot accurately and effectively process all the information that is available to us, we use simplifications or shortcuts to make decisions.

Hotel investments decisions are typically uncertain. Current valuation and expert techniques consider multiple economic factors such as RevPar, Occupancy rates, economic forecasts, and the availability of resources in a particular region. However, classical conceptualizations of economic value maximization and decision making never happen under perfect rationality. In addition, engaging in a hotel development project spans several years during which the initial investment conditions - if they are known - and assumptions are likely to change. This makes a hotel investment choice complex and dynamic. While there is no doubt that economic factors play a central role in hotel investment decisions, high levels of uncertainty force decision-makers to focus on the most salient signals and in doing so lead to heuristic simplifications.

One proven means to gain legitimacy for strategic actions, respond to competitive moves, and reduce the uncertainty of own investment decisions is to look at peer-group behavior. The popular belief that "if others do it, it must be right" assumes that others know best. Through this lens, information gaps are discounted to make fast decisions and justify own strategic activity. Curious about the extent to which this happens in practice, we conducted a study to identify such herding behavior in hotel construction decisions.

To what extent does herd mentality impact hotel investment decisions?

In a study of 2'598 US-based hotel projects, we modeled hotel pipeline patterns over 12 years (2006-2018) to assess the extent to which prior development decisions influence the likelihood of new hotel projects. Results indicate that decision-makers are likely to mimic others' hotel development decisions, regardless of market conditions and property-specific characteristics. This positive pull effect is best described as a herding funnel: ongoing hotel development projects are likely to encourage more of the same. Such a pattern suggests that hotel construction decisions are indeed influenced by social pressures of peer-groups' investment behavior.

What does this mean for hotel developers and investors?

While we do no doubt that decision-makers are rational human beings and make important fact-based decisions, our research argues that decisions and value assessments in corporate real estate investments are biased. Instead of focusing solely on the costs and benefits of a particular investment choice, hotel investment decisions are simultaneously impacted by imitation tendencies that allow executives to justify quick market entry choices in an uncertain market environment. In this way, hotel market entry decisions might not be based on the absolute best hotel market location in a portfolio of potential investment possibilities but rather based on the best hotel market available among hotel peers' entry decisions. An awareness of herding behavior should enable executives to better reflect on their own evaluations and make a conscious effort to suppress cognitive biases. Such awareness will make room for more sound decision making based on objective economic assessments.

[1] Bain (2019). Bain's beliefs on strategy. Available from: http://www2.bain.com/story/bain-beliefs-on-strategy/index.html (Accessed 2 September 2019). As well as, Lee, S.k. & Jang, S. (2017). Early mover or late mover advantage for hotels? Journal of Hospitality & Tourism Research, 41(1), pp. 23-40.

Achim Schmitt

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Samrah AlShawi

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