HOTEL CURRENTS™ | Inflation: Implications for Hotel Investment

By Jack Corgel, Ph.D.

March 2, 2018New voices entered some of our lives in the past couple of years. I refer to virtual assistants, such as Alexa and Siri. They are so proficient at answering questions about many topics, I assigned them a much more ambitious task: provide guidance about inflation in the U.S. —past, present and future. The decision to challenge these nice ladies in such a way is based on: (a) both having access to “big” databases and (b) the guidance about inflation offered by economists is unfulfilling. Why not ask Alexa and Siri? There might be some kernels of wisdom overlooked from my reviews of the professio​nal and academic literature on why inflation has lagged in recovery and may accelerate soon. Given a keen interest in hotel markets, my goal is to understand how hotels will perform should inflation finally become a major concern.

Consensus from Economists About Inflation: Don’t Hold Your Breath!

Economists began seriously thinking about inflation around the time of the American Revolution. With all the accumulated knowledge about an economic condition that affects the lives of nearly everyone, shouldn’t one expect that a consensus explanation would have been reached by now 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 (i.e., 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 conceptualizations, in addition to explaining current inflation levels, is prediction of future inflation. Others point to CPI and PCE 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. (See here and here). This common-sense explanation for low inflation and the prospect for more precise inflation measurement unfortunately offer no predictive powers. 

Economists generally agree that the Phillips Curve relationship has lost ground as a policy tool. Recent research tosses more dirt on “the Curve” (Dotsey, Fujita and Stark, 2017). Nevertheless, efforts continue to prop it up with econometric innovations (Nalewaik, 2016). Turning to the Fisher Equation, one frontier of research on the expected inflation component involves rectifying disagreements about future inflation among professional economists responding to surveys such as those sponsored by Blue Chip and Consensus Economics (Brito, Carriere-Swallow and Gruss, 2018). 

I take the liberty here to 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 breakeven inflation rate (i.e., difference between a Treasury security yield and TIPs yield of the same maturity) 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. 

Alexa and Siri, You’re Up

The virtual assistants were asked the following questions:

  • What is inflation?
  • Why has inflation in the U.S. been so low during the past few years during the economic recovery?
  • How much will inflation in the U.S. increase over the next few years?
The good news is Alexa and Siri understood the questions; the bad news is the answers from the virtual assistants aren’t worth the cyberspace in which they were created! 

Asked “what is inflation,” Alexa regurgitated the first sentence found in the Wikipedia definition. Siri simply said she found the Wikipedia definition and for me to go there for my answer. On the question about low inflation, Alexa stated “I don’t know that one” while Siri located six articles on the subject that I had read following a Google search. Finally, Alexa said she was “not sure” about future inflation—a more honest answer than would have come from some pundits—while Siri again found articles about forecasts of future inflation, which I also had read.
Alexa and Siri, please pick up your participation trophies!

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: 

  • The percent change in 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.
  • The academic and professional literature follow the trends described above. Many more papers about inflation and real estate investment were written between the 1970s and 1990s than during the past 17-plus years. 
  • Economists think about inflation as that which is anticipated (aka 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 Equation (1).

    ​Actua​l Inflation ​= Anticipated Inflation + Unanticipated Inflation
    ​(1)
    ​​​where anticipated inflation has been measured using the 10-year historical changes in Treasury rates and recent per​cent changes in CPI (see, for example, Miles and Mahoney, 1997).​
  • ​​Inflation affects monetary assets (i.e., cash and legal claims to fixed amounts of money now and in the future) differently than real assets (i.e., 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 owners of monetary assets (e.g., lenders) to those with monetary liabilities (e.g., borrowers/equity investors). 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​!
Real estate fund managers often contend that real estate investments provide a good hedge against actual inflation. These statements have merit in theory, especially for anticipated inflation, given that real estate is a non-monetary asset. However, the accumulated evidence from many empirical studies conducted in various parts of the world fails to produce a consensus (see a recent review by Dabara, et. al., 2016). Nevertheless, some property types potentially provide better, albeit not perfect, hedging ability than others. Huang and Hudson-Wilson (1997) offer the following conclusions:

"We show here that the conventional wisdom that real estate, as an asset class, is an effective inflation hedge is overly generous. We do find that the different property types exhibit more and less effectiveness at hedging expected and unexpected inflation. If we want to use real estate as a hedge, we must be aware of the differences across property types, or else run the risk of thinking we have a hedge when in fact we do not."

More discussion appears below about different property types when I address the hotel case. But first, 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’ IRRs. My favorite article on this subject was written during the heyday of U.S. inflation in 1978 by a long-time friend, Ken Lusht. At the risk of oversimplifying Ken’s elaborate presentation, I demonstrate his ideas using the most basic of valuation formulas, shown in Equation (2).

Value (V) = Income (I) / Rate (R) 
(2)
Positive movements of I in the numerator over time will have positive influences on V. 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 (a) c​​​ontractually allowed to rise and (b) can be raised along with other increasing prices.​
Positive movements of R in the denominator of Equation (2) have the opposite effect of pushing V down. We know from the Fisher Equation that inflation is a meaningful component of R. And from research, we know that the “denominator effect” on V exceeds the “numerator effect” on V. Nevertheless, Lusht shows that the net effect of inflation on V only should vary with capital structure and tax rules. Debt and taxes have leading roles in the inflation/value production.  

Lusht’s model and simulations offer the following results:

  • Inflation has a depressing effect on V to the extent that transfer costs and, more importantly, capital gain taxes are based on nominal gains in V. 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 V in the presence of rising inflation. As discussed above, unanticipated inflation becomes an instrument of wealth transfer from owners of monetary assets (e.g., lenders) to those with monetary liabilities (e.g., borrowers/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 V to decline as inflation unexpectedly increases. These expenses remain fixed in many property situations and by law are not indexed for inflation. 
To summarize, inflation strikes the numerator and denominator of Equation (2) from different channels and these strikes tend to offset one another. Capital gains treatment, fixed-payment debt and depreciation rules create situations in which highly levered, non-depreciating assets benefit the most from inflation, while all-equity, depreciable assets are most negatively affected. 

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 may be considered superior property investments during periods of accelerating inflation. I have often heard this argument 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 revenues and incomes behaved relative to inflation over the past several decades. Exhibit 1 shows the history of real changes in ADR, RevPAR and NOI (i.e., each hotel performance measure minus the change in CPI-U). The picture leads to the preliminary conclusion that hotel incomes serve as a hedge against inflation in good times and not during economic downturns, especially those exacerbated by unexpected shocks. 

Exhibit 1.


The data display in Exhibit 1 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. Both Econbroser (2018) and Kirby and Rothemund. (2018) reach the conclusion that 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.

Conclusion

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.

References

  • Brito, S., Y. Carriere-Swallow, and B. Gruss. 2018. “Disagreements about Future Inflation: Understanding the Benefits of Inflation Targeting and Transparency.” IMF Working Paper, January.
  • 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.  

  • Acknowledgement: Kelcie Sellers assisted with this blog.

    FOR MORE INFORMATION REGARDING THIS ARTICLE, PLEASE CONTACT:

    ​​Jack Corgel, Ph.D.
    ​​Managing Director, CBRE Hotels’ Americas Research
    ​Professor of Real Estate at the Cornell University School of Hotel Administration

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