For this discussion I went back to the Raub Reports in February and March 2009 as the stock market crash ended and inflation was a big topic then, too.
Inflation Rate in 2021
Inflation has become a significant issue on our national economy in the past 6 months with the October reading a shocking 6.2% annualized, when we have barely reached 2% annually over the past 10 years, since the so-called Great Recession. This is the fastest rate in 30 years.
Inflation in a Healthy Economy
It is generally accepted that 2% inflation is a sign of a healthy, growing economy and this has been the Federal Reserve’s (FED) target. But the Covid Crisis has thrown everything out of kilter. Will this inflation be “transitory” just as we hope the pandemic will become and the supply chain disruptions? Or will inflation be more prolonged and stick around longer, as it did in the 70’s when it spiked to over 11% in 1974, 1979 and 1980? This year has seen good growth in wages across the board, because of labor shortages, however, this is wiped out by a higher increase in inflation. And there is always a new Covid variant to worry about.
What is inflation really?
Inflation can be described as,
1) A decline or dilution in the real value of money.
2) The loss of purchasing power.
3) The dilution of the buying power of your money.
That is to say, your dollar buys less goods and services than it once did. Inflation is really the government creating too much money and this waters down the buying power of the existing money supply. Prices going up are actually a result of inflation and your dollar just buys less stuff.
Is inflation a good or bad thing?
Economists agree that a small amount of inflation is healthy for the economy. Our population grows about 1.7% a year, so we need to create about 2 million new jobs yearly and we need to grow our GDP at about that rate, too. The FED’s primary mandates are “full” employment and to control inflation and they accomplish this by means of controlling the money supply through interest rates. Now, we have negative real rates, as inflation is much higher than interest rates. This is essentially a tax on everyone, falling hardest on the low income earners who cannot hedge inflation by owning investments that are expanding with inflation.
Source of Inflation
The source of inflation is both the huge monetary stimulus injected by Congress and then the FEDs intervention in the markets by buying treasuries, mortgages and corporate bonds. In 2008, the FED had less than 1 trillion on its books. Before Covid, it had escalated 400% to $4-trillion and now it stands at $8.6-trillion. However, it is beginning to taper its $120-billion per month bond and mortgage purchasing which will end in June, so their balance sheet will stop growing. It is assumed then it will shrink as these investments mature and payoff, and are not replaced.
One thing is very certain – interest rates are raising and will rise several points in the next 2 years. This is because the economy is recovering and demand for loans is expected to climb. And if inflation persists, as most expect, the FED will try to limit excessive inflation by raising the underlying FED funds rate. This dampens demand for loans as they become more expensive, but runs the risk of tipping the U.S. into a recession as the FED has done repeatedly. Higher federal interest rates also compete with the stock and real estate market for new investments. Right now, no one is very happy with nearly no income from C.D.s. If interest rates rise, then yields of 3% to 4% become attractive again, versus the volatile stock market. Especially, if and when we tip into a bear market and recession. Money likes to go where it will grow safely.
What is the effect of Inflation on Commercial Real Estate?
CRE acts as a store of value so that when the money supply is inflating, then your property value is rising, too. Part of this comes from the intrinsic value of land and buildings and part comes from the income stream.
Commercial leases vary in length and thus the ability to respond to inflation. The shortest term leases are in apartments and self-storage which typically lock in rates for 6 to 12 months before renewing with the possibility of a rate increase by the owner. On the other hand, office, industrial and retail leases generally run from 3 to 5 years in length and then, some leases to major companies for large spaces may run ten years with renewal options. These leases typically include set rent increases, often fixed at two to three percent per year to account for inflation. That has worked fine for the past decade when inflation has generally averaged below 2% annually but now with the potential for persistently higher inflation in store, these Landlords may end up behind inflation’s push rather than on top or head of it.
During periods of high uncertainty about inflation, like the 1970’s, the rent increases were keyed to the Consumer Price Index. In the past years, however, CPI has not been used as an index to increase rents; just a fixed annual increase of, say 2%, in rent rates to keep up with expected inflation. Now, I expect that CPI adjustments will be re-introduced into lease negotiations. Bottom line – the Landlord wants the ability to raise his rents as fast, or faster than the rate of inflation. Landlords want short leases with CPI escalations, Tenants want long term fixed rate leases.
How does Inflation affect your mortgage?
The value of your mortgage is being paid down by your monthly payments of principle. But inflation helps you because your mortgage is declining in real dollars as the value of the dollar declines. You are paying it off with inflating dollars. And the value of the property is, hopefully, going up faster along with the pace of inflation. So your equity, which is a smaller part of your property’s value is going up at the rate of inflation while the real value of your mortgage is declining, magnifying the increase in value of your investment.
With interest rates near historic lows, it is absolutely time to put in long term low interest loans to maximize the value of your investment and lock in your biggest cost, interest expense, for decades to come.
Commercial Real Estate can perform well in an inflationary period because,
1) Property, like gold, is a store of value (I am not going to address crypto currencies which need more time to sort out their volatility).
2) The rents can be raised to keep pace with inflation.
3) Your loan declines in real dollar value.
It is best to anticipate inflation now.