Inflation Rears its Ugly Head

A great deal more concern is being expressed today about a resurgence of inflation than has been heard for many years. Former Fed Chairman Paul Volcker, who was responsible for bringing the very high rates of inflation under control in the early 1980’s, recently warned about the risk of rising inflation resulting from current fiscal and monetary policies that he feels are too expansive. Worries about inflation are strengthened by quite a number of other factors, including the following:

1. 1. Soaring petroleum prices
2. 2. Record high commodity prices
3. 3. A declining U.S. dollar
4. 4. Rapidly rising import prices
   
5. 5. A huge U. S. budget deficit

With inflationary pressures building, it seems inevitable that the Federal Reserve Board will continue raising interest rates, and speculation is growing that the Fed may have to accelerate the rate at which these increases are put into effect.

Higher interest rates will definitely have a dampening effect on the U.S. real estate market, both for leveraged and for all-cash investors. While inflation is a negative for real estate in the short-term, real estate is a real asset and the costs of constructing a building have been in a consistent uptrend since mankind first began keeping records. Therefore, real estate has been considered an inflation hedge in the past and, with properly structured lease terms, it can also provide protection against inflation today.

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Inflation’s Effect on Real Estate: Long-Term

There have been many times in the past when real estate has been looked upon as an investment that provided a hedge against inflation. This is primarily due to the fact that real estate is a real asset, and the cost of constructing real estate has been in an almost constant uptrend. Forty or fifty years ago an office property that traded at $100 per square foot was considered fully priced. Today that same office building might trade at from $200 to $300 per square foot. Construction costs, particularly labor costs, have gone up over time, and in recent years the cost of building materials - steel, cement, and glass - have risen sharply. In addition, land costs have risen, particularly for well-located land in major metropolitan areas. The overall growth of the U.S. economy and the growth of population have increased the demand for land that can be developed in prime locations. So basic growth and inflationary pressures in the economy can cause well-located and well-maintained buildings to increase in value.

Even more importantly, real estate will increase in value as the rental income from the property rises. Any fixed income investment, such as a bond, will decline in purchasing power during an inflationary period. Therefore, when investing in a property it is essential that the property have rental increases built into the existing lease, or be in a market in which supply/demand factors are such that rental increases can take place as leases roll over. The ability to raise rental rates for a given property is one of the most important factors that has to be considered when selecting a property for investment.

Equally important is the ability to pass on operating expense increases to the tenant. Real estate investors have learned from previous inflationary periods how important it is to have leases that, in one form or another, require the tenant to absorb either all of the operating expenses at a property or absorb all increases in expenses over the initial base year of the lease. Having an increasing net operating income is a major consideration for any potential real estate investment.

Inflation’s Effect on Real Estate: Short-Term

Although over a complete business cycle inflation has the effect of increasing the value of the physical property itself and will also bring about higher net operating income from the property, in the short run inflation can have a depressing effect on real estate values. While the huge budget deficits of the Federal Government and the excessive growth of the money supply are the two factors that cause inflation, they are also the two factors that the Government turns to when it decides that it must try to control inflation. And since it is politically difficult to control Government spending and bring the deficit under control, the primary tool that is used to fight inflation is the monetary one. This means that the Federal Reserve Board has to raise interest rates high enough to make it unattractive for businessmen and investors to borrow.

As interest rates rise in the real estate market, upward pressure is put on capitalization rates. For the leveraged investor, mortgage interest rates will rise in line with Government bond yields and this will bring down the cash-on-cash returns for that investor, unless capitalization rates move up at the same time. With higher interest rates, all-cash investors will be able to find competing high-yielding alternatives in other asset classes. And if interest rates reach a level that overall economic activity is restrained, this can have a negative effect on the basic operating environment of the real estate market.

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