February, 1999 - Deflation is defined as “a sustained reduction in the general level of prices of goods and services”¹.  Deflation is often, though not inevitably, accompanied by declines in output and employment, and is distinct from “disinflation” which means a reduction in the rate of inflation. 

There are two types of deflation: one which is devastating, and the other is sustainable and mild.  The former, last seen during the Depression, is marked by prices that fall because there is not enough demand from consumers.  The latter, last experienced during the Industrial Revolution, occurs when prices fall because both production and productivity take wing, and both workers and companies can afford to keep demand strong at lower prices; however, as wages fall, prices fall even faster. 

Accustomed to the very high growth rates in revenues over the last three years or so, hotel managers, investors, and developers expect ever higher prices for their services and assets.  But there is now concern among economists about the possibility of deflation, albeit sustained and mild, taking place in the U.S.  With all the efficiencies imputed by the current technological revolution, are we close to the day when most services and goods we buy will behave in the manner personal computers do, getting cheaper month after month?  If deflation does take place, how would it impact the U.S. lodging industry? 

Many hotels are now finding that they cannot easily raise room rates.  Some major properties in the San Francisco Bay Area, one of the strongest lodging markets in the nation, are facing the deflationary pressures of economic turmoil in regions such as Southeast Asia, and have started to cut room rates.  Moreover, over the last year there has been an increase in supply in principal markets, imposing additional pressure on hotel managers to think twice before raising room prices.  In the past three years, nearly 500,000 new hotel rooms have hit the U.S. market – the equivalent of all the hotel rooms in Orlando and Las Vegas.  In 1998 (ending October), the total Las Vegas hotel room inventory, for instance, increased by 5.6 percent over 1997, while visitor volume has decreased by approximately -0.2 percent; total gaming revenues increased by only 2.1 percent.  Other areas of the country, such as Atlanta and Dallas, have recently been recognized as having too many new hotel rooms and not enough guests. 

If investors sense the arrival of deflation in the U.S., to protect themselves they would start to avoid businesses with high labor and capital, such as hotels, which become more burdensome if there is pressure to reduce prices.  While today’s hotel valuations do not seem too high in relation to underlying earnings, owners who have borrowed excessively may be in trouble, and any weakening in demand triggered by overseas turmoil would hurt prices.  In a deflationary period, the damage is further magnified by the borrowing that owners or developers undertook to buy hotel assets, as collateral collapses in value.  To protect profits in deflationary periods, hotels must either cut costs or generate more demand, thus the primary goal for most hotels confronting deflation would be to gain market share, making top-line growth a significant issue.  But with all the new supply entering the market, intensifying the competition for guests in most segments, coupled with prices reaching a plateau after three years of incessant growth, the challenge would be significant.

The outlook for hotel real estate investments would be mixed if the U.S. fell into a mild deflation.  The majority of hotel segments, except for luxury resorts, which are generally immune from market gyrations, would be hurt if people and companies felt like saving their money and cutting back on travel spending.  Such a cut back scenario is always lingering, especially as consumers are exposed to the effects of volatile global capital markets and an overvalued domestic stock market that continues to defy fundamentals. 
 

1  The Dictionary of Economics, 1989, (London: Century Hutchinson), Page 105.