Real Estate and Inflation

“Today, people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that governments will follow in their effort to alleviate the current crisis will probably prove inflationary and therefore accelerate the decline in the real value of cash accounts. . . Those investors who cling now to cash are betting they can efficiently time their move away from it later.”
— Warren Buffett

Warren Buffett is, of course, one of the most famous and most successful investment advisors in the history of the United States. Situated in Omaha, Nebraska, far from the power centers of New York and Washington, he has compiled an outstanding investment record by adhering to a long-term investment strategy. And while his focus is primarily on the stock market, his philosophy, as recently expressed above, can be applied equally well to long-term equity investments in real estate.

The concerns of investors at mid-year 2009 are quite different than they were a year ago or even six months ago. It seems safe to say today that the doomsday scenario, which had become so prevalent in 2008 and had scared investors so badly, has not come to pass. The stock markets of the world are rallying; the bond markets are behaving more rationally; and signs that the global recession is bottoming out are multiplying. The emerging countries of China, India and Brazil are now expected to show positive real growth in 2009, and the United States is now expected to recover well ahead of Europe, the United Kingdom and Japan.

But investors still have two concerns, as mentioned in Mr. Buffett’s statement above – inflation and timing. Inflation must be looked upon from both a short-term and a long-term viewpoint and, from either viewpoint, it has to be considered a major factor in investment decisions today. Properly selected and professionally managed real estate can provide an investor with protection against the inflation expected to result from the current economic crisis, just as inflation has increased the value of real estate on a long-term basis.

As to timing, many investors, both individual and institutional, are betting, as Mr. Buffett suggests, that they can successfully time their move out of cash and into real estate at some later date when the market has “hit bottom”. In Falcon’s view there are two problems with this approach: one, most investors will only know that the bottom was reached six to twelve months after it happened; and, two, even if they were astute enough to recognize that the market was at the bottom, the very nature of the real estate market makes it almost impossible to find and close a significant number of real estate transactions in a short period of time.

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Inflation

There is no question that a resurgence in inflation is becoming an increasing concern on the part of many economists. The Wall Street Journal editorializes on the subject regularly. The enormous increase in the money supply and the huge U.S. budget deficits, which are occurring as a result of the various economic stimulus packages, are looked upon by many economists as certain precursors of inflation. And similar policies are being carried out in countries around the world. As oil recovers to $70 per barrel and gold flirts with the $1,000 level, these are seen as signs that inflation will become a more serious problem as the economy begins to recover in 2010. But the real impact of long-term inflation can be illustrated by the fact that just ten years ago – in 1999 – oil sold at $16 per barrel and gold ended the year at $288 per ounce.

Real estate, as a real asset, is an investment that that can provide a hedge against inflation. This is at least partly due to the fact that the cost of constructing real estate has been in an almost continual uptrend. Thirty years ago the cost to build an office property was usually below $100 per square foot. Today that same office building might cost from $400 to $500 per square foot or more. 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. They have retreated during the current recession, but are beginning to move back up again in anticipation of the global economic recovery.

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. Finding undeveloped land in cities such as New York, Boston or San Francisco is almost impossible. So basic growth and inflationary pressures in the economy will cause well-located and well-maintained buildings to increase in value.

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