Finance

Debt Hitch-Hiking:

How Hotels Found

Low-Cost Capital
Here’s how some hotel companies have been "’paid" to borrow money and how to
determine when your firm might achieve a net negative cost of capital

by Avner Arbel
and Robert H. Woods
OVER THE PAST several years
many observers have asked the
question, how has the hotel indus-
try been able to develop so many
properties? Our answer is, the
industry went on a construction
binge primarily because many
hotel companies have been able for
at least the last 15 years to borrow
money at almost no cost. That’s
right-nearly free money! Between
Avner Arbel, Ph.D., is professor of
finance at the Cornell University
School of Hotel Administration.
Robert H. Woods, Ph.D., is an
assistant professor at the School of
Hotel, Restaurant, and Institu-
tional Management at Michigan
State University.
1974 and 1982, hotels in the U.S.
able to borrow money at zero
were
cost, and, in fact, in many
hotel companies actually
on the debts that they
money
incurred to build new properties
during this period. The level of
construction in the past 15 years
has left many markets temporarily
unable to absorb the rapid expan-
sion in hotel rooms, but wouldn’t
you build another hotel if lenders
paid you to use their money?
While this situation has changed
somewhat since 1982, many hotel
companies still pay very low
effective real interest rates for the
money they borrow. In effect, then,
hotel companies are still &dquo;smart&dquo; to
borrow for construction, in the
sense that they are able to borrow
large sums of money for almost no
cost. Actually, the hotel industry is
also apparently much more effective
at incurring debt than companies in
cases other industries, as indicated by a
made comparison to the Standard and
Poor’s 500 companies.
How Has This
Situation Occurred?
Two phenomena typically cause
astonishing results in economics-
government intervention and
inflation. Each by itself can bring
about incredible effects. The two
combined can often lead to absurd
consequences. A case in point is the
cost of borrowed capital for hotels
in the last decade and a half.
Before we discuss how the
negative cost of capital has affected
the hotel industry as a whole,
consider the following example for
a single hotel company (all num-
bers presented are annual aver-

105

Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015

The hotel industry is effective
in hitch-hiking on inflation, but
the U.S. government probably
benefits more substantially
from rapid inflation than any
other ®rr~ r®
Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015
ages). For this illustration we at fixed rates, as has been typical
intentionally selected a period of for the hotel industry for many
time that includes years of rela- years, interest payments are stated
tively high inflation. and paid in fixed amounts regard-
The interest rate at which this less of changes in the purchasing
company borrowed funds on its power of the dollar. However, the
long-term debt between 1974 and income of hotels is not fixed. On
1982 was 9.25 percent (this num- the contrary, past evidence clearly
ber is calculated by dividing the shows that hotel income usually
actual interest payments by the goes up with, or often exceeds, the
average outstanding debt for each rate of inflation. In fact, hotels’
year and then calculating a simple average daily rates have exceeded
average for the whole period). the rate of inflation in all but three
Since interest payments are tax years over the past decade and a
deductible, however, that was not ha If.22
the company’s true cost of capital. As a result of the combined
Instead, tax deductions over this impact of fixed borrowing rates and
period of time substantially low- room-rate increases, the inflation-
ered the company’s real cost of adjusted (real) cost of debt incurred
capital to 5.6 percent. by hotels goes down. In other
How do taxes lower the real cost words, while hotel companies
of debt? The answer is tax deduc- borrowed money at yesterday’s
tions. The actual tax rate for this rates (and when the dollar was
company for the period was 39.5 reasonably strong), they repaid the
percent. This meant that the cost debt with current, weaker dollars
of serving the loan was split and, given continuous inflation,
between the government and the will eventually repay these debts
company in such a way that for with tomorrow’s further decayed
every dollar of interest paid, the money. That arrangement repre-
government paid 39.5¢. The rest sents a net gain for the hotels as
(60.50 per dollar) was paid by the long as hotel room rates and
company. Therefore, the nominal incomes continue to go up at at
after-tax cost of capital to the least the rate of inflation. As a
company between 1972 and 1988 result, the real cost of debt is
1
was only 5.6 percent. approximately equal to the nomi-
While this 5.6-percent cost of nal interest rate minus the rate of
capital rate would be very appeal- inflation.3 In fact, the larger the
ing to most companies, it is still not difference between room-rate infla-
the effective cost of debt to the tion and the nominal interest rate,
company. and if revenues do not decline in
real terms, the more you make as a
Inflation Hitch-Hiking Trends in the Hotel Industry (Worldwide
2
While the tax deduction offered by Edition), Pannell Kerr Forster, 1989; and U.S.
Bureau of Labor Statistics, 1989.
the government significantly The following approximation is widely used
3
reduces the real cost of debt to to explain the practical impact of inflation on
interest:
hotel companies, it is not the only
factor that has led to free capital.
We also must consider the effects of
inflation hitch-hiking.
Consider the impact of inflation t=0 is the cost-of-living index at the
CP1
beginning of the year;
on debt. As long as loans are taken t=1 is the cost-of-living index at the end of
CP1
the year;
1
T he after-tax cost of borrowed capital can n
iis the nominal rate of interest expressed as
be calculated by multiplying the nominal a decimal; and
interest rate by 1 minus the corporation’s tax r
iis the real interest rate expressed as a
rate. In this case, (1-.395) (.0925). decimal.
106
 _

borrower and the more you can
hitch-hike on inflation.
The idea of inflation hitch-
hiking can be illustrated in more
general terms by the following
example. If you were to borrow
in raising its room rates as infla-
tion increased. Consequently, the
company was able to reduce its
effective cost of debt to a level
much lower than the 5.6-percent
rate we previously calculated. In
people’s money for making money.
Two sub-periods are evident in
these data. The first was 1974-82,
when the rate of inflation was
relatively high and the cost of debt
was usually negative (ranging from

money and invest it passively in a
riskless (and hypothetical) security
such the Consumer Price Index
as
(CPI), you would receive no real
return and your cost would equal
the cost of borrowing. Because this
investment is linked to the rate of
inflation through the CPI, the
purchasing power of the invest-
ment would remain the same. On
the other hand, when you invest
such borrowed money in income-
generating ventures such as hotels,
income is linked to inflation but the
current borrowing cost and the
principal are not. Consequently,
the cost of your borrowed money is
reduced by the full extent of the
inflation rate, and you actually
would receive the borrowed money
free of charge because of the asym-
metric impact of inflation. While
your income from the borrowed
money goes up with inflation, the
cost of borrowing does not. Fur-
thermore, if you smartly invest the
money to yield a positive return,
this &dquo;other-people money&dquo; grows for
you because you have used infla-
tion for your benefit. In effect, you
have hitch-hiked on inflation to
make money.
The Real Effective
Cost Of Debt
To compute the real effective cost
of debt, one must include the
impact of both taxes and inflation.
This can be summed up as follows:
Real Effective Cost of Debt = borrowed capital.
Nominal Rate x (1-Tax Rate) -
Inflation Rate
To illustrate this formula, let’s
the actual numbers for the
use
hotel company previously men-
tioned. Like most other hotel
companies, this one was successful
fact, between 1974 and 1982 the -8.05 percent to +0.16 percent). The
company actually raised its room average cost of debt was an aston-
rates by an annual average of ishing -3.5 percent during this
above 10 percent. Therefore, the time. The second period was
effective real cost of debt for the between 1983 and 1988, when
company during this period was inflation was more moderate. Dur-
ing the later period, the average
.0925 (1-.395) -.10 = -.044
cost of capital for the industry
In other
words, this firm en- ranged from 2.24 percent to 6.36
percent, and the average cost for
joyed negative cost of capital of
a
4.4 percent. the five-year time span was 4.7
As a result, during this time percent.
Four factors account for the
period the hotel company was, in
higher cost of debt during the
effect, paid 4.4 percent to use other
second period identified above: (1)
people’s money. Obviously, making
this kind of money on large the reduction in tax rates due to
amounts of debt provided a sizable tax reform, (2) the introduction of
incentive for the hotel company to variable-rate loans, (3) lower
borrow as much as possible, and to inflation rates, and (4) the in-
build as many hotels as it could.44 creased use of high-rate junk-bond
financing toward the end of the
Industiy-Wide Real Effective period. Nevertheless, in spite of
Cost of Debt these factors the effective borrow-
To calculate the industry-wide ing rate for hotels has been ex-
effective cost of debt we have tremely low and remains so today.
To understand the impact of this
analyzed data from the Value Line
Investment Survey, from Standard low cost of debt, you should con-
and Poor’s Compustat Database, sider the large dollar amount
from Merrill Lynch Equity-Screen, involved. For instance, in 1980
and from 10K reports.’ The dif- alone, when the real cost of debt for
ferent components of the effective the hotel industry was -8.05
cost of debt are presented in percent, the companies in our
Exhibit 1 (next page). For the 15- sample had total debt of $1.1
billion. In other words, in that year
year period as a whole, hotels were
alone the industry made at least
effectively paid, on the average,
about 1 percent to use other $88 million just by borrowing
money!
The cost of debt for this company, as in the
4
case of most other hotels, has risen to the point
While the figures presented
that it is no longer paid to borrow money. The above are substantial, they still do
company still pays relatively little for its not capture the full benefit of the
In 1982, these companies had a combined
5 borrowed money during inflation
outstanding debt of nearly $3.5 billion. By 1988, because they ignore the inflation-
that number had risen to $5.1 billion. Value Line
and Compustat compile information from all ary impact on the principal bor-
large hotel corporations traded on various stock rowed. The decline in purchasing
exchanges, as well as some medium-size and
small hotel companies. We used the 10K reports power of the borrowed capital
for some companies to supplement data that between the maturity date and the
were missing in other sources and to spot-check
the estimates for smaller hotels not included in date on which the loan was initi-
the above data sets. ated (and money received and

107

Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015

invested mostly in tangible assets
that produce inflation-adjusted
income) can also significantly
reduce the cost of borrowing.66
Large vs. Small Companies
While the effective cost of capital
for the industry as a whole was
very low, there are some anomalies
even within the set of companies
we examined. For instance,
consider the differences between
large and small companies. Both
large and small hotel companies
were able to keep their real cost of
debt very low during this period,
but the debt cost for small hotel
companies was substantially
higher than that for large com-
panies. One of the reasons for this
finding is that smaller companies
involve a greater lending risk, so
they must pay higher interest
rates. They also typically
experience lower tax rates, so the
While we could not evaluate the impact of
6 suffers and nobody gains from in-
this factor due to the lack of detailed available
data on debt duration, we did determine the
impact of variable-interest loans when such
loans were taken. The effect was included in the
way nominal rates were calculated. We took the
actual interest payment, as reported by the
company (including rate adjustments when
relevant), and divided it by the average debt
outstanding.
Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015
’ still helps by allowing tax deduc-
tax-deduction benefit is mitigated.
Smaller companies usually borrow
for shorter terms, and a longer loan
duration generally lowers the
effective cost of borrowing because
of the effect of inflation. Finally, in
the extreme case of a company that
lost money, there is no tax benefit
and consequently the cost of capital
is higher than for a profitable
company-all other things being
equal.
How Can Debt Be Free?
Usually, economic theory assumes
rational expectations (i.e., all parti-
cipants in financial market trans-
actions are assumed to correctly
anticipate inflation). As a result,
inflation is supposed to be built
into the pricing mechanisms of
capital. In theory, the return on
capital to the lender or the cost to
the user is always assumed to be
fair in real-cost terms. In this
theoretical world, therefore, no one
flation, because rates are always
fully adjusted for inflation at all
times. But in real life, the scenario
is different in at least one critical
respect-actual inflation frequent-
ly differs from expected inflation.
108
As a result, incurring debt is
usually not a zero-sum game.
Instead, in the real financial world
the winners those who more
are
accurately predict inflation and the
losers are those who do not.
Ironically, as past evidence
shows, the disparity between real
and anticipated inflation is typi-
cally greatest during periods when
an accurate prediction of inflation
is most important, notably during
periods when prices rise rapidly.77
The result is that inflation does
create losers and winners-
depending on whether the borrow-
ers or the lenders predict inflation
more accurately. However, even
when borrowers fail to predict
inflation correctly, the government
tions based on the nominal cost of
debt.
Is the Hotel Industry Unique?
While all borrowers benefit from
tax advantages and from borrow-
ing money at low rates during in-
flationary periods, the hotel
business is particularly effective in
the hitch-hiking game. The hotel
industry is not alone in its ability
to ride inflation for low or no debt
costs, however. Interestingly, the
U.S. government probably benefits
more significantly from rapid
inflation than any other borrower.
It is not widely known that in 25 of
the last 55 years, the U.S. govern-
ment has incurred a negative cost
of borrowing on both its short- and
long-term bonds and notes. In fact,
the average real cost of borrowed
capital to the government over this
55-year period was zero! So, we
conclude that the hotel industry is
in good company in this enduring
party of inflation hitch-hiking.
The following five characteris-
tics make the hotel industry one of
the most adept free riders of all
For example, see: William F. Sharpe,
7
Investments, second edition (Englewood Cliffs,
NJ: Prentice-Hall, 1981), pp. 80-81 and 224-248.
industries. (1) The industry is capi-
tal intensive. (2) The industry’s
real-estate component provides
excellent guarantees and collateral
for loans that are perceived by
lenders to be inflation resistant.
Consequently, interest rates for the
hotel industry are relatively low.
(3) The industry is highly
leveraged. In fact, in relative terms
the hotel industry borrows more
than any industry, except for
airlines, real estate, and banks.
Indeed, in 1990 the debt-to-equity
ratio for the hotel industry as a
whole was 2.1 compared to an
average of about 1 for all public
companies in the U.S.~ (4) Hotel The disparity between the hotel at low cost-all thanks to the
companies usually have longer- industry’s effective cost of debt and generosity of government and
term debt than most companies. By that of the Standard and Poor’s 500 lenders who misread inflation.
in
locking large sums of debt for companies is made even more
realistic Future Hitch-Hiking
longer periods time, of hotels can by applying dollars to the
take better advantage of the full percentages. For instance, there is The hotel industry’s ability to
impact of inflation. (5) Hotels are an average 5.1-percent difference hitch-hike on inflation may not

perceived to be highly effective in between hotels and the S&P 500, continue in the future. If nominal
adjusting room rates to the general as shown in Exhibit 2. What this interest rates are fully adjusted for
price inflation.9 This characteristic means is that if the Standard and inflation either as a result of better
of the industry is the most critical in Poor’s companies had been able to inflation prediction by lenders or
its ability to hitch-hike on inflation. incur debt at the same effective by more intensive use of variable
As a result of this fifth character- rate as the hotel industry over this rate loans (that periodically adjust
istic, the hotel industry is much period, they would have saved an for inflation), the phenomenon of
more successful at raising low-cost average of over $35.1 billion in debt low-cost capital may disappear. If
debt capital than most industries. service on a combined average this occurs, the effective cost of
To verify this point we compared annual debt of $685 billion. In 1981 debt capital will be too high for the
the real cost of debt for the hotel alone the savings would have industry to continue to expand at
industry as a whole with that of the amounted to $51 billion. the same rate as in the past.
companies in the Standard and The hotel industry’s ability to Indeed, there is evidence to suggest
Poor’s 500 Index, a group of widely outperform the Standard and that the overbuilding that occurred
watched companies that are gener- Poor’s companies over a relatively in the hotel industry during the
ally regarded as benchmarks in long period of time may be the first half of the period under
financial markets. The comparison result of financial &dquo;smartness&dquo; (i.e., consideration has been balanced
is presented in Exhibit 2. accurately predicting inflation). somewhat over the past few years
More likely, though, it is the result in large measure by the rising costs
Media General, Dow Jones Retrieval,
8
September 28, 1990, estimates for 5,400 public of being in the right industry to of debt capital and the cumulative
companies. hitch-hike on inflation. Again, both negative effects generated by the
For further discussion,
9 see: Avner Arbel and
Paul J. Strebel, "The Hotel Industryas a Hedge the ability to borrow initially at anomaly of free capital.
Against Inflation: The Empirical Evidence," The relatively low rates due to the real- On the other hand, the hotel
Cornell Hotel and Restaurant Administration
Quarterly, 20, No. 3 (November 1979), pp. 4-7; estate component and then to raise industry may be able to hitch-hike
Avner Arbel and Paul J. Strebel, "A Micro-Test
of the Rational-Expectations Hypothesis: The
prices rapidly in inflationary times as effectively in the future as it did

Case of the Hotel Industry," The Journal of
Economics and Business, 33, No. 1 (Fall 1980),
pp. 66-71; and Avner Arbel and Paul J. Strebel,
"Money Illusion and Inflation Management in
Tourism: The Hotel-Industry Case," The Annals
of Tourism Research, 7, No. 3 (April 1981),
pp. 395-405.
are very important. Whatever the in the past. The capital markets
cause, the hotel industry got have frequently underestimated
billions of dollars of capital yielding coming inflation, particularly in
hundreds of millions of dollars of
periods of severe inflation. As a
return from other people’s money result, the real cost of borrowed

109

Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015

hotels overcome the
current excess capacity and
are once again able to raise
their rates and revenues in
tandem It inflation, the
of low-cost debtt
will return.
capital for hotels in almost all past tion of the rate of inflation because
high-inflation years was close to the reverse (lower inflation than
zero before taxes and significantly predicted) will excessively raise the
negative after taxes. Therefore, a cost of borrowed capital, as was the
keen predictor of inflation may still case for hotels that borrowed
be able to hitch-hike effectively. heavily during the peak of the
However, the other necessary inflation in 1979-1981 and thereby
condition for effective hitch-hiking locked themselves into punishing
should not be forgotten-namely, high interest rates.
the hotel industry should be able to
The Impact of Free Money
raise prices and revenues in tune
with the general inflation rate. The While the hotel industry has been
able to borrow at low or no cost for
existing situation of overbuilding
makes this more difficult, of course, most of the past decade and a half,
and impossible in some cases. there is clear evidence that this
was not a free ride for the industry.
Predicting the Future In retrospect, it is pretty obvious
Clearly, inflation alone does not that rapid overbuilding throughout
determine the effective cost of debt, the industry is one by-product of
but as we have illustrated it was a the free money that hotels have
very significant factor in the hotel been offered over this period.
industry. Therefore, it stands to Indeed, if the recent inability of the
reason that accurately predicting industry to raise revenue faster
the future rate of inflation is one than inflation continues, we can
way of knowing whether or not the conclude that the free money has
hotel industry will continue to re- caught up with the industry and
ceive either free or low-cost capital. that this phenomenon will not be
With a no-money-back guarantee, repeated even during high-inflation
we offer the following benchmark periods. That view would suggest
that may help with this prediction. that free money was simply an
Several studies have shown that anomaly for a period of time that
the capital market perceives the has now ended. Remember, the
current yield on six-month trea- ability to adjust room rates and
sury bills as a good indication of revenue in tandem with inflation is
inflation expectations. To find the a key for inflation hitch-hiking.
current rate of six-month treasury Also, the provisions of the Tax
bills, simply check The Wall Street Reform Act of 1986, more exper-
Journal. In the past, the yield of ienced and sophisticated financial
that security over the long term markets, and the broader use of
has been about zero in real terms variable-rate loans all suggest that
(i.e., after inflation). Therefore, this the anomaly is less likely to re-
number can be used as a bench- occur at least in the near future.
mark of the consensus of financial Over the longer run, however,
markets regarding future inflation. we believe that once hotels over-
If you anticipate significantly come the current excess capacity

higher inflation than the six-month
treasury bills for any reason and if
you believe that you will be able to
increase your room rates at the
rate of the treasury bills without
reducing revenue in real terms, you
should consider becoming an
inflation hitch-hiker. However, you
must be right about your estima-
and are once again able to raise
their room rates and revenue in
tandem with inflation, the phenom-
enon of low-cost debt will return.
Indeed, while it appears that this
phenomenon is cyclical, it also
appears to be an inherent charac-
teristic and advantage of the hotel
industry

110

Downloaded from cqx.sagepub.com at UCSF LIBRARY & CKM on March 22, 2015