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Will the COVID Fiscal Response Be the Spark That Finally Ignites Inflation?

Will the COVID Fiscal Response Be the Spark That Finally Ignites Inflation?

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Inflation hawks have been howling since the policy response to the dot.com crash of 2000 that a return to a 1970s style inflation was imminent. As reasonable as some of these expectations and arguments may sound, the reality is that inflation, as measured by the Consumer Price Index (CPI), has not materialized in any meaningful way. Average inflation from 2000 to 2009 was 2.54%. CPI from 2010 to 2019 was even lower than the century’s first decade at 1.75%.

Some of the hawks would argue that consumer price inflation has been replaced by asset price inflation, a process in which excess money flows to stock, bond and real estate prices rather than consumer prices.

If they are right, we may be facing an inflationary threat on two fronts. First, like the potential energy of water behind a dam, a pent-up “potential inflation” in the form of high asset valuations could flow to consumer prices. Second is yet another massive government fiscal response (and monetary co-operation) from the Federal Reserve in reaction to the COVID pandemic.

While the pandemic has inflicted significant economic damage, the policy response has been unprecedented even compared to past crises.

A recent Washington Post story notes that “the Fed and White House appear closely aligned on policy… With Powell at the Fed, and his predecessor Janet Yellen serving as treasury secretary, neither power center regards the potential dangers of overspending as a top concern.”

Though policy and lawmakers may not publicly show inflation concerns, there are troubling signs on the horizon.

The Wall Street Journal reports that manufacturing surveys indicate “global delivery times were the second-longest on record in February” and that “factories reported the sharpest rise in the prices they pay for inputs in almost a decade, and they in turn, raised the prices they charged.”

Another story in the Post – What used cars tell us about the risk of too much inflation hitting the economy, observes that used car prices “soared 17% nationally in seven months last year.” Though not as dramatic, the uptick in prices for food and appliances followed used cars.

Commercial Real Estate as a Hedge Against Inflation

Savvy investors have long used real estate to hedge against the effects of inflation on investment and savings. While location and physical structure are important components of valuation, rental income ultimately drives commercial real estate performance.

The ability to increase rents during inflationary periods with lease renewals is crucial. While other businesses may pass along price increases, they also face margin pressure as input costs rise. In other words, higher income is traded for higher expenses.

Commercial real estate enjoys the rising rents without the same pressure on operating costs. In addition, increasing labor and materials costs make competition for new real estate development less likely.

A 2011 research paper from the University of Pennsylvania Law School Institute for Law and Economics (ILE) authored by Bradford Case and Susan Wachter took a look at actual real estate investment returns in inflationary environments.

The ILE paper chose to focus on REIT returns based on the transparency of the information and the ability to measure performance in various property types. Of particular note are the findings regarding commercial real estate returns during 1974 to 1981, the type of environment that still strikes fear in those who lived through it.

“The period 1974-1981 was the most inflationary eight years in the history of the Consumer Price Index at 9.3% per year, but equity REIT returns easily preserved purchasing power, with income and total returns averaging 10.2% and 16.3% per year.”

The study notes that while commodities may provide the highest inflation protections during significant periods of inflation, they may lose substantial value in lower inflationary environments, while commercial real estate still provides strong return characteristics.

Thus, real estate benefits from both consumer price inflation and asset inflation. An investor is well-positioned whether a significant and scary inflation returns or a more modest rise in price levels occurs.


Which Property Types Fare Best in Reaction to Inflation?

The key factor for commercial real estate keeping up with inflation is lease terms.

Multifamily housing is particularly well suited for inflationary environments. With typical lease agreements of twelve months’ duration and tenants’ hesitancy to move due to the expense, lessors can generally obtain annual rent increases.

Another advantage that multifamily enjoys, though not particular to inflation, is that tenant risk is diversified. Retail and office properties are often dramatically impacted by a single tenant, while multifamily properties can have hundreds of units.

This is where a skilled property manager can add significant value for an investor. While vacancy is always part of the commercial real estate equation, managing the vacancy rate is a critical component of success. In fact, extremely low rates may indicate that rents are too low. Efficiently managing tenant turnover is another important aspect of effective property management.

Astute management and development may take advantage of emerging opportunities. The pandemic’s onset combined with existing demographic trends indicates there may be a window to convert distressed hotel properties (or nearly developed hotels) into senior living facilities.

Be Prepared

Federal Reserve officials have repeatedly spoken of a seemingly elusive 2% inflation target. With Democratic control of Congress and the Treasury and Fed in sync, investors should expect further inflationary policy.

But as history has shown, once the inflation genie is out of the bottle, it is near impossible to contain. Investors should have a plan to combat such forces to protect the purchasing power of their savings and wealth. One tactic may be an investment in commercial real estate and, in particular, multifamily housing. An experienced, professional commercial real estate development and management company can increase the chances of success when navigating potential turbulence.