Kevin Warsh’s speech on Friday was not what hotel investors waiting for lower interest rates wanted to hear.
Warsh didn’t commit to a rate increase, but he also made clear that the Fed is prepared to raise rates if inflation does not move toward its 2% target quickly enough. Markets are now pricing in roughly a 58% chance of a 25-basis-point increase in September, and some economists expect another before the end of the year.
That would be especially frustrating for investors who have spent the last few years sitting on the sidelines. Deals that did not work at a 7% borrowing rate were supposed to look better once rates came down. Instead, some of those properties have sold, improved, or simply disappeared from the market while buyers waited for financing conditions that still have not arrived.
The obvious bad news for hotel investors is that borrowing costs may go up again. But the bad news didn’t begin with Warsh’s speech. Hotel owners have already been absorbing it for years through higher payroll, insurance, supplies, utilities, repairs, and PIP costs. Another rate increase would make capital more expensive, but it would also be a response to the inflation already eating into hotel margins.
Interest rates are one of the tools the Fed uses to control inflation: lower rates make it cheaper to borrow and spend, which creates more demand throughout the economy, which can keep pushing prices and wages higher when the supply of goods, services, or labor does not keep pace. Raising rates is intended to slow that spending and, eventually, the rate at which prices increase.
Here’s how that shows up on a hotel owner’s P&L.
Higher rates increase debt service, reduce loan proceeds, and make acquisitions and refinancing more difficult. But higher rates also make borrowing more expensive throughout the economy, which means consumers and businesses tend to borrow and spend less. As demand cools, companies have less room to keep raising prices. That doesn’t necessarily mean prices decline; it means, ideally, that they stop increasing so quickly.
Hotels do have one advantage over many other businesses: they can reprice their rooms every day. But room rates are still constrained by what the market will bear. Guests do not pay more because the hotel’s insurance premium increased or its PIP became more expensive. When operating costs rise faster than ADR, the difference comes directly out of the hotel’s margin.
Higher rates could eventually slow the growth of some hotel expenses. They could also weaken business and leisure travel, making it harder to increase ADR. Meanwhile, the effect on owners with floating-rate debt or an upcoming refinancing is much more immediate.
That is the difficult position hotels are in. Lower rates would make debt easier to manage, but lowering them before inflation is under control could allow operating costs to keep climbing. Higher rates may help slow those costs, but they can also make the hotel more expensive to finance and its rooms harder to sell.
Warsh may be signaling the rate the economy deserves after several years of elevated inflation. It just isn’t the rate hotel owners need right now.
