Imagine a game of Monopoly(™ Parker Brothers) in which the money supply for each player was infinite. You would see a glut of houses on all available spaces, followed in due course by a glut of hotels. Players would never go bankrupt, and all available spaces would be built until they could not physically hold any more wooden house/hotel tokens. Relaxing the normal constraints would make it a very dull game, with little suspense involved.
Well, that’s basically where we are today with the Fed’s monetary policies. The glut of houses happened in 2007; we are now seeing the glut of hotels. Needless to say, just as the housing glut became a deep depression with massive loss of wealth, so too today’s glut of hotels will shortly come to an unpleasant end.
The hotels glut has been building for several years. Having spoken at a hotel conference in 1999, I am the lucky recipient of a weekly newsletter, the International Hotel Investment News, detailing bids, deals and expansion in the global hotel industry. This has been extraordinarily bullish for about five years now, and last week reported that 2015 was yet another record year for lodging transactions, with deal volume up 56% in the first half of the year worldwide and 73% above last year’s level in the United States. Total deal volume in 2015 is expected to come in at $68 billion. The largest of these transactions, Marriott’s takeover of Starwood, is expected to create the world’s largest hotel company with 1.1 million rooms. Overall, IHIF described 2015 as a “dead sprint toward high occupancy and record rates.”
While business and leisure travel have also been increasing year by year, the world’s slow economic growth must put a cap on them – as evidenced by the positively spooky deserted nature of a large luxury hotel in Stamford, CT. in which I spent a day just before Christmas. Not the high season, admittedly, but Stamford is a very prosperous town and a major nexus of the hedge fund and financial sectors – in other words one of the world’s solidest and best hotel markets.
The problem is worldwide; Hong Kong retail sales are reported to be down in absolute terms this year because of a dearth of Chinese tourists. You can bet that Hong Kong hotels, an exuberantly overbuilt market, will also be hurting badly. The Macao casino business, also, is down by about two thirds following China’s crackdown on corruption.
What’s more the hotel space is being disrupted by Airbnb, the agency for private apartment and room lettings, which currently has only $900 million in projected revenues this year but in 2015 raised $1.5 billion in new venture capital on a $25.5 billion valuation, double the valuation of Starwood, the object of the year’s largest hotel M&A transaction. As we know from the retail business in 2008-09, that kind of disruption has to produce bankruptcies somewhere, either of the disruptor (unlikely with such a well-funded operation) or among the disrupted.
You would expect a hotel bubble. The Fed had ensured that banks have oodles of money to lend at ultra-low interest rates, generally below the rate of inflation before the risk premium is added in. That has naturally caused a surplus of investment in real estate, which has apparently stable cash flows that can surplus gigantic amounts of debt if the interest rates are low enough. In 2004-07 the surplus went into housing. Then the market crashed, negating participants’ assumptions about the invulnerability of home values to market decline.
This time around, the memory of pain from housing is too recent, so that sector has remained relatively controlled (though a price rise of 5.2% nationwide in the year to October, at a time when general inflation is about zero, indicates that exuberance has not entirely disappeared.) Retail real estate, too, had produced a lot of losses in 2008-09, as the Internet shook up the sector and consigned major operations such as Blockbuster Video to irrelevance. The hotel sector, on the other hand, has no recent history of major disaster and apparently had the right sort of steady income, especially in the luxury sector, which could be used to support a mountain of debt. Thus in November 2015 the number of hotel rooms under construction was 21% above the previous year (which was already a buoyant market), with some markets such as Los Angeles/Long Beach up over 100%.
The junk bond market is already in trouble, largely because of energy sector financing that depended on $100 oil. During the course of 2016, it is likely to see wave after wave of defaults and downgrades, as companies run into difficulties and discover that their cash flow is insufficient and refinancing possibilities have dried up. The tightening in the junk bond market and the leveraged loan market will also affect the hotel sector, as companies with unexpectedly tight cash flow and big expansion plans find themselves unable to raise the necessary finance.
The result will be a credit market Armageddon, similar to that of 2007-08, but this time not confined to housing. Just as in 2007-08, financial institutions will find themselves caught in the resulting backwash. This time, however, the biggest losers will not be the investment banks caught in the intricacies of securitized housing finance but the banks themselves, which will have lent directly against energy and hotels, without having laid off all the risk on unfortunate German regional banks through securitization. The downturn will prove that it is not necessary to be large and financially sophisticated to get into difficulties; if the Fed pursues extreme monetary policies even the simplest bank business strategy can go drastically wrong.
Monopoly™ was originally invented to show the evils of real estate speculation, and popularize Henry George’s (1839-97) eccentric theories on land ownership, which held that all land should be held in common with any increases in its value taxed at 100% to contribute to the needs of the state. The game failed to move the needle much on the popularity of George’s beliefs, but we can expect that a real financial crisis, which will appear to have been caused by excessive property speculation, will bring George’s theories very much back into vogue.
In 2008, the left asserted that the crisis had been caused by a lack of sufficiently detailed bank regulation, rather than by a combination of crazed Fed monetary policies and Federal meddling with the housing market to achieve social goals thought to be desirable. This time around, apart from a general demand for more regulation and more state spending, it seems unimaginable that we will escape demands for higher taxes. Thus a George tax on land value appreciation (without the George preference for abolishing all other taxes to make way for it) seems a likely demand, concentrated on the rich and with a certain amount of plausibility in the claim that it is relatively economically un-damaging.
Monopoly™ is realistic in that it is an excess of money in the game which produces bankruptcies; if money is limited the smart player concentrates on acquiring railroad stations and reaping the modest but steady rewards from those genuine operating businesses. Only when the amounts of money in the game become huge does the concentration of hotels become excessive and the game become a form of financial Russian Roulette with massive, indeed excessive rewards for the winners and total wipeout for the losers. Sound familiar?
The solution to the current cycle of massive overbuilding in real estate and speculative projects, producing massive and destructive bankruptcy cycles once a decade is simple as in Monopoly™ – reduce the supply of money and make it more expensive to borrow. Our current economy, if operated with sound money and light regulation, would produce all the productivity gains of the halcyon period 1948-73.
God knows the inventiveness of U.S. engineers has not declined, and they have now been joined by a massive new force of equally gifted engineers from the rest of the globe, many of whom 50 years ago would have been engaged in subsistence farming without adequate communications with the hubs of innovation. Far too many resources are going into futile Monopoly™-like speculation, and this is the fault of over-loose monetary policy. The solution is simple, and the Fed and its fellow central banks should implement it forthwith.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)