While revenue per available room exceeded what I predicted in 2012, it was primarily because some of what lies ahead is slower to arrive than I had thought. The bubble is growing, and unless Washington—and especially President Obama—act to reduce entitlements and overall spending and accomplishes true tax reform, the result of the bursting bubble someday will be very ugly.
The projections of valuation increases going to the sky, which come forth from some appraisers, are based either on not understanding the macro issues, or simply intentional puffery to make everyone feel good. Similar to what they said at New York University’s International Hospitality Industry Investment Conference in 2008, when it was predicted that the worst was over, RevPAR was still headed higher, and it was time to buy again. Just in case you forgot that speech.
If you are investing in assets or projecting the growth or decline of net operating income, you need to understand what is really happening. First, by now, you surely understand the federal government’s spending is out of control, and it simply cannot continue. Entitlements are currently 50% of the federal budget and will soon be up to 67%. That is not a typo. There is no possible way that can continue. The number of retirees grows everyday by thousands, and the young workforce to pay the bill is at a far lesser percentage than it has been. There are 4.5 young people paying for each retiree, and it is headed to 2.8. The math does not work. We are about to add tens of millions to Medicaid through “Obamacare,” and there is simply no way to pay for that other than through higher taxes, which that law mandates, plus the $680 billion from the December fiscal cliff deal, and more tax increases to come.
The sequester reduced the rate of growth of the deficit; it did not reduce the deficit. The tax code is absurd and unfair. Regulations continue to pour out of Washington raising your cost of doing business. For these, and many other reasons, the economy is now in its slowest post-recession growth in post-depression history. Because of the refusal of Obama to agree to any real deficit reductions, there is little chance this will all change for quite awhile—possibly years.
So that left the Federal Reserve to try to bail out the economy by pouring trillions more liquidity into the economic system through the first, second and third quarters, and driving interest rates to unrealistically and unsustainably low levels. It is estimated by the Fed, and other economists, that rates should be around 65 basis points higher than they are, if the Fed was not manipulating the bond market. Right now, the Fed buys 80% of all new treasury issues. That is more than two times what is normal. In short, the bond market, the lending market and credit markets overall, are being manipulated by the Fed to try to save the economy from the inability of Obama and Congress to deal with the real problems.
It is not a real free market at all. So values today are higher than they should be due to rates being 65 basis points lower than a free market rate. Capitalization rates are therefore lower, proportionately, than they should be. As a result, capital is being driven into buying hard assets, stock market equites and real estate markets, and is being financed by unrealisticly low rates. In time, the bubble will burst and the price will get paid. The Fed cannot keep doing this forever. When they stop, the bond market will decline, all lending rates will go up rapidly and the stock market and asset values will decline, possibly by a lot. There is no way to know when, but it is going to happen. Because the Fed is manipulating the bond market, the market signals that one normally hears from trading of debt securities are absent because traders have no real say. The Fed has the say. We are, as a result, in an asset bubble that will come to shreds one day when QE3 ends and the Fed is no longer able to cover for the fiscal mess. That will combine with the realization that the U.S. is no longer a sound economy due to a massive deficit that is swallowing the private capital side through massive new taxes just to pay the far higher interest rates required to fund that deficit, which when QE3 ends, will suddenly make the current deficit seem small.
The U.S. has a serious problem because of the lack of leadership in Washington. On the surface it might appear the economy is getting better, and it is on the surface, but beneath the sunny surface of the economic ocean is a tidal wave headed for shore. That is exactly what happened in 2008. People stood up at NYU that year giving happy spin and completely misunderstood what was really happening, while some of us were busy selling out as fast as we could. It is like that recent Florida sinkhole tragedy. The house on top looked fine, but underneath the ground was sinking and nobody noticed until it was too late to save the man.
I am sure many will say, “Here goes Dr. Doom again, and he was wrong last year about RevPAR.” I can only tell you that in November 1993, when we created the first hotel commercial mortgage-backed security programs, we predicted it would eventually all crash in a terrible collapse, and in June 2007, I was all in cash and not reinvesting until March 2009. My ability to predict exact timing might be off, sometimes by years, but the long-term trends are absolutely clear to many of us who are not trying to snooker the rest of you into believing the happy gas is the real world.
So you need to stop listening to the puff and predictions of great increases in values over the next years and pay close attention to the reality of the Fed, the credit markets, interest rates, and where they are really headed over time. You might do well for awhile, but at some point in the next several years, you will get caught holding illiquid assets if you are not paying close attention—just like in 2008.
Joel Ross is principal of Citadel Realty Advisors, successor to Ross Properties, the investment banking and real-estate financing firm he launched in 1981. A pioneer in commercial mortgage-backed securities, Ross, along with Lexington Mortgage and in conjunction with Nomura, effectively reopened Wall Street to the hotel industry. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross is also the author of Ross Rant, a commentary on the economy, financial markets and politics that is available through his website, www.citadelrealty.com.
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