The question of whether hotel owners are insulated against rising inflation in the U.S. is often debated, but fully understanding inflation can help hoteliers prepare for it.
ATLANTA—With the rise of virtual assistants like Alexa and Siri and their proficiency in answering questions about almost anything, can they provide solutions to inflation in the U.S.?
This question is based on two assumptions: Both have access to “big” databases, and the guidance about inflation offered by economists is unfulfilling. Why not ask Alexa and Siri? There might be some kernels of wisdom overlooked from reviews of the professional and academic literature on why inflation has lagged in recovery and might accelerate soon. Unfortunately, neither Alexa nor Siri could provide substantive insights about inflation, its behavior in the last few years or what it might do in the future.
Given a keen interest in hotel markets, our goal is to understand how hotels will perform should inflation finally become a major concern.
Consensus from economists about inflation
With all the accumulated knowledge about an economic condition, is there a consensus explanation for the persistence of low inflation in the post-recovery U.S.? Some economists who focus on guiding monetary policy believe too many chips were placed on the Phillips Curve square—empirical results showing that as the unemployment rate falls, the inflation rate rises—and on the Fisher Equation, which includes expected inflation as a main argument. The promise with both concepts, in addition to explaining current inflation levels, is prediction of future inflation.
Others point to Consumer Price Index and Personal Consumption Expenditures price index measurement problems related to the impacts of technological and demographic changes on prices. And still others believe that downward price pressures on goods such as toys, wireless services and household goods traced to technological advances offset price increases in other sectors. This common-sense explanation for low inflation and the prospect for more precise inflation measurement unfortunately offer no predictive powers.
Let’s assume a consensus actually exists among economists that the inflation rate in the U.S. is more likely to rise than fall in the coming years. Recent increases in the recorded inflation rate and in the break-even inflation rate suggest that the bear might be awakening, albeit probably with a slow exit from the cave. The possibility that an unexpectedly hungry bear might eat the lunch of investors ups the ante for understanding how rising inflation affects monetary and real asset positions.
Does property ownership provide a hedge against inflation?
To seed the discussion about the relationship between inflation and property investment, a few concepts and facts need highlighting.
First, the percent change in Consumer Price Index for All Urban Consumers, or CPI-U—the most common inflation measure—has not exceeded 4% since 1991, and the change in Core CPI has remained below 3% since 1994. Between 1973 and 1982, inflation measured by the percent change in CPI-U was greater than 5%, peaking at 13.5% in 1979.
Economists think about inflation as that which is anticipated—or expected—and unanticipated. Anticipated inflation is foreseen both in its level and timing. Pricing incorporates anticipated—but not unanticipated—inflation. Actual inflation encompasses both types, as indicated in the following equation.
Actual Inflation = Anticipated Inflation + Unanticipated Inflation
(*Anticipated inflation has been measured using the 10-year historical changes in Treasury rates and recent percent changes in CPI.)
Inflation affects monetary assets, like cash and legal claims to fixed amounts of money now and in the future, differently than real assets—claims that can change in the amounts of money received. Inflation is sometimes described as a tax on monetary assets and, in the case of unanticipated inflation, an instrument of wealth transfer from lenders or other owners of monetary assets to borrowers and equity investors, or those with monetary liabilities. Positions in real assets have a chance of being protected from inflation taxation given the changes that can occur in money received. However, there are few guarantees.
Let’s drop back a step and think about inflation and investment value at a conceptual level, recognizing that sale prices at the end of holding periods contribute a lot to investors’ internal rates of return. Consider the most basic of valuation formulas, shown in the equation below.
Value (V) = Income (I) / Rate (R)
Positive income over time will have positive influences on value. These movements come from favorable demand and supply conditions in the future that increase the price of space (i.e., rent and room rates) and come from inflation assuming rents and room rates are contractually allowed to rise and can be raised along with other increasing prices.
Positive movements of rate in the above equation have the opposite effect of pushing value down. We know from the Fisher Equation that inflation is a meaningful component of rate. And from research, we know that the “denominator effect” on value exceeds the “numerator effect” on value. Nevertheless, the net effect of inflation on value only should vary with capital structure and tax rules. Debt and taxes have leading roles in the inflation/value production.
Inflation has a depressing effect on value to the extent that transfer costs and, more importantly, capital gain taxes are based on nominal gains in value. For decades, economists have argued that capital gains should be indexed for inflation to avoid erosion of investor wealth over time. In a world of tame inflation as seen in the U.S. over the last 17-plus years, this issue moved back into the shadows. If inflation accelerates to a runaway level, watch for indexing to resurface.
Larger debt-to-equity ratios increase value in the presence of rising inflation. As discussed above, unanticipated inflation becomes an instrument of wealth transfer from lenders to borrowers and equity investors. When inflation moves upward and the prospect for unanticipated inflation increases, the incentive to take on more fixed-payment debt is heightened.
Depreciation expenses cause value to decline as inflation unexpectedly increases. These expenses remain fixed in many property situations and by law are not indexed for inflation.
The hotel case
Hotels hold the unique position in the commercial real estate sector because of management’s ability to adjust rental rates each day, and therefore might be considered superior property investments during periods of accelerating inflation. This argument often comes up when inflation is discussed by hotel professionals. Note that similar claims also can be made for other property types, as follows:
- Office: Many office leases have monthly CPI escalators.
- Retail: Percentage leases call for landlords to receive shares of tenant sales, which grow with the economy and coincidently (usually) with inflation.
- Multifamily: Short-term leases provide landlords the opportunity to avoid repeated annual beatings from inflation.
Let’s see how hotel revenue and income behaved relative to inflation over the past several decades.
The chart below shows the history of real changes in average daily rate, revenue per available room and net operating income—each hotel performance measure minus the change in CPI-U. The picture leads to the preliminary conclusion that hotel income serves as a hedge against inflation in good times and not during economic downturns, especially those exacerbated by unexpected shocks.
The chart data refers to the numerator of a hotel valuation equation. Because the rate in the denominator has expectations built in, the contribution of inflation is not easily computed. Approximately one-half of the recent run-up in the 10-year treasury rate came from inflationary expectations. The 10-year treasury rate is an important component of hotel capitalization rates. If we assume that recent estimates hold for other periods, then any hedging advantage occurring in the numerator of the valuation equation will likely be offset by inflation-induced rate increases.
Here are the takeaways:
- The current and expected inflation rates in the U.S. are tame.
- Unanticipated runaway inflation will differentially affect hotel property values, depending on debt financing and tax rules.
- Hotel revenues and incomes likely will hedge inflation during economic expansions but not during periods of economic declines.
As for future runaway inflation in the U.S., I need to hedge by saying “I am not sure,” to quote Alexa.
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Dabara, D. I. et. al. 2016. Real estate Investments and the Inflation Hedging Question: A Review. International Journal of Business and Management Studies 5(1): 187-196.
Dotsey, M, S. Fujita, and T. Stark. (2017) “Do Phillips Curves Conditionally Help to Forecast Inflation?” Federal Reserve Bank of Philadelphia, working paper, August.
Econbrowser. 2018. A Fisherian Decomposition of the Recent Interest Rate Increase. February 9.
Huang, H. and S. Hudson-Wilson. 2007. Private Real Estate Equity Returns and Inflation. Journal of Portfolio Management (Special Issue): 63-73.
Kirby, M. and P. Rothemund. 2018. “REITs on Sale” Heard on the Beach, Green Street Advisors, February.
Lusht, K. M. 1978. Inflation and Investment Value. AREUEA Journal 6(1): 37-49.
Miles, M and J. Mahoney. 1997. Is Commercial Real Estate and Inflation Hedge? Real Estate Finance 13(4): 31-45.
Nalewaik, J. (2016) “Non-Linear Philips Curve with Inflation Regime-Switching,” Federal Reserve Board, working paper, August.
The assertions expressed in this article do not necessarily reflect the opinions of Hotel News Now or its parent company, STR and its affiliated companies. Please feel free to comment or contact an editor with any questions or concerns.