It was not long ago that the U.S. economy was stuck in an inflationary rut. Throughout much of the recent economic recovery, inflation — as measured by the U.S. Consumer Price Index — has risen less than 2 percent a year. Some years, it barely scratched the surface of 1 percent, despite the Federal Reserve’s extraordinary efforts to stimulate economic growth.
It seems the times they are a-changin’. An ultra-tight labor market, more-robust growth in consumer prices and the Trump administration’s fiscal stimulus policies — including the $1.5 billion tax cut signed into law at the end of 2017 — are a few of the factors that recently have stoked inflation-related worries.
The CPI rose 2.9 percent during the 12-month period ended in June (not seasonally adjusted), the fastest rate since early 2012. The index for all items less food and energy rose 2.2 percent over the same period. The Fed’s preferred inflation gauge, the core Personal Consumption Expenditures price index, stood at 1.9 percent in June, and the central bank expects it to rise to a median of 2.1 percent in 2019 and 2020.
Meanwhile, interest rates are trending upward, albeit gently. In mid-June, the Fed hiked its benchmark short-term interest rate for the seventh time since it began normalizing policy in late 2015. The Fed, which has signaled it will raise rates two more times this year, considers 2 percent inflation to be consistent with its dual mandate to foster maximum employment and stable prices.
“Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly,” the Fed wrote in a statement announcing its latest rate hike.
RISING RATES
What are the implications for real estate investment in a stronger inflationary environment?
Interest rates, of course, are one of the biggest drivers of real estate activity. An extended period of rising rates could drive up capitalization rates — buyers would theoretically be willing to pay less for properties — and depress valuations, leading to a buyers’ market. Higher rates also may mean higher debt payments for some existing owners, especially those seeking to refinance in a rising-rate environment.
“Sometimes real estate, perhaps for a year, maybe 18 months, can shrug off the impact of rising bond rates,” says Richard Barkham, CBRE’s global chief economist. “But it can’t do that forever. Normally, in the longer term, if bond rates go up, cap rates go up and vice versa.”
But it is also important to consider why interest rates are rising. Higher rates are typically a sign the economy is on solid footing, as it is today. The tight labor market and recent surge in business investment bode well for income-
producing real estate.
In fact, commercial property prices continued to climb in early 2018, with the value-weighted CoStar Commercial Repeat Sales Index rising by slightly more than 9 percent during the 12-month period ended in April.
Despite the recent uptick in inflation, few economists expect a replay of the 1970s, when, despite a weak economy, inflation spiked owing to an oil crisis, monetary policy and what has been described as a self-fulfilling prophecy of higher prices leading to higher wages leading to higher prices. In the early 1980s, the Fed hiked interest rates sharply to curb inflation, eventually bringing both the economy and inflation to a standstill.
“We have seen some upward movement in inflation, but we have to keep in mind what’s going on,” says Calvin Schnure, Nareit’s senior vice president of research and economic analysis. “We’re still in a period of relative price stability. Instead of weak inflation, which is usually a sign of a weak economy, we are in a period where inflation is back around where the Fed is comfortable seeing it.”
HEDGING BETS
Anticipated inflation actually can fuel demand for private investment in income-producing real estate, which is widely seen as a hedge against rising prices because landlords can raise rents as leases roll over and rent-escalation clauses are common in commercial property leases. The clauses are often tied to the CPI or some other measure of inflation.
“We get a lot of investor interest in hard assets because of inflation,” says Linda McDonald, a vice president in the Alpha Investment Research Group of Segal Marco Advisors. “There are several reasons investors consider real estate: the diversification benefits, income potential and, to a lesser extent, inflation protection.”
Yes, interest rates — and other costs — should continue to rise, says McDonald. But a strong economy also should push up net operating income for commercial real estate, mitigating the impact of rising rates, she notes.
“It could end up being a zero-sum game,” explains McDonald. “If the economy is doing well, that means fundamentals are strong — vacancy rates are low and net absorption is good — assuming there is not an oversupply.”
Although concerns exist about the level of construction in some markets, particularly for apartment projects, ground-up development has been relatively subdued in recent years and appears to be tapering off as the recovery stretches into its ninth year. According to a Nareit report, construction activity has slowed since early 2017 and remains below its long-term trend relative to gross domestic product. That bodes well for vacancy rates, rents and property valuations in the months ahead, according to the report.
Rising construction costs also should keep a lid on development. Turner Construction Co.’s quarterly Building Cost Index, which measures nonresidential U.S. construction costs, has been steadily rising since at least 2014. In second quarter 2018, the index rose nearly 2 percent from the previous quarter and was up almost 6 percent on a year-over-year basis. A shortage of skilled labor — and, in some regions, unskilled labor — and higher raw-material costs are fueling the run-up in construction costs.
“We’re getting later into the cycle, and development has been pretty moderate relative to prior cycles across all property types,” says Lee Menifee, head of Americas investment research at PGIM Real Estate. “For real estate returns overall, I would have to say that rising construction costs should be a net positive” by serving as a check on development, he adds.
As with construction, commercial real estate debt levels have risen at a more measured pace than they did during previous cycles, according to CBRE. Overall, asset values in the United States are well above their pre-recession peak, but the ratio of commercial real estate debt to GDP (about 21 percent) is still more than 2 percentage points below its previous peak, as of May 2018, notes CBRE.
While REITs have fallen out of favor with many investors as interest rates have trended upward, Nareit’s Schnure says they are well positioned to handle higher rates, thanks to prudent planning. During the recovery, REITs have not only reduced debt levels by taking advantage of robust capital markets to raise equity, but also extended the average maturity of their debt, which now stands at about 75 months, he said. REIT leverage, as measured by debt-to-total assets, is at its lowest level in 20 years, according to Nareit.
“Compared to previous cycles, real estate is not highly leveraged,” says Barkham of CBRE. “Quite often in real estate, people borrow too much money, and they develop too much property. But we have not seen either of those things this time” around, he adds.
Although commercial real estate is broadly viewed as a hedge against inflation, as with anything, the devil is in the details. In an inflationary environment, properties with shorter-term leases, such as apartments, may prove more resilient than those with longer-term leases, such as industrial buildings, because landlords can raise rents on a regular basis.
Meanwhile, net leases — which require tenants to pay, in addition to rent, some or all property expenses — may be preferable to gross leases when costs are climbing, says PGIM Real Estate’s Menifee.
“In an environment where rates may be rising, the growth of the income stream is at least as important as the security of the income stream,” he says. “When we look at leases, the ability to raise rents in the future is very important for a property to maintain its value. That, in many cases, may be more important than the credit that’s on the lease.”
SHRINKING THE FED’S BALANCE SHEET
In mid-May, the yield on the 10-year Treasury note — a benchmark that guides other interest rates — briefly hit 3.12 percent, its highest level since 2011. But shortly thereafter, inflationary worries gave way to other types of worries, including trade fears and weaker emerging markets, that capped the note’s prior move upward. Yields fall as prices rise.
The Fed’s so-called Big Unwind — a nickname for the central bank’s plan to slowly pare the enormous balance sheet it amassed during the financial crisis — is expected to put upward pressure on long-term borrowing costs. But, according to some economists, we are nowhere near the types of interest rates that could derail real estate activity.
“As the Fed allows its balance sheet to shrink, that will probably have longer-term rates moving up,” says Schnure. “The unwind is going to take away the stimulus the sector has had and, at some point, it could result in a brake on [real estate] activity, but we are a long way off from the types of interest rates that would slow activity.”
By moving slowly and deliberately, the Fed hopes, among other things, to avoid a repeat of the 2013 taper tantrum, when the central bank announced its decision to taper its bond-buying program and Treasury yields surged as a result. So far, the impact on broader markets has been mild, but, as CoStar’s Justin Bakst points out, we are in uncharted territory.
“The Fed is trying to go through a quantitative [tightening] cycle at a time of rising interest rates,” says Bakst, director of capital markets. “The question is, how will the markets react? If there’s a hiccup, we’ll see a jump in long-term rates.”
CYCLICAL FORCES
For some, the big question is why inflation is not more robust this far into the recovery. The answer, says CBRE’s Barkham, is tied to the fact workers have long been reluctant to push for higher wages despite the tight job market.
Suffering from a fear hangover from the global financial crisis, many still worry their jobs will be outsourced or lost to automation. While wage growth beat expectations in May, it remains well below historic trends, according to CBRE.
And despite the Trump administration’s America-first policies, the forces of globalization continue to march on, which keeps a lid on prices and wages, says Barkham. He also notes, although oil prices have rallied recently, they remained low for several years thanks in part to the U.S. shale-oil boom and other factors that have undercut OPEC’s influence on prices.
“We’re in a very advanced stage of the cycle, with low unemployment, but still have no real material inflation building,” says Barkham.
Indeed, the return of more-robust inflation has largely been met with a collective shrug by many real estate experts. And for some it is actually welcome news.
Anna Robaton is a freelance business journalist based in Portland, Ore.