The Monthly Multiple: June 2021

June 22, 2021

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What We Talk About When We Talk About Inflation

The Labor Department reported a 4.2% year-over-year increase in the core consumer price index (CPI – the main measure of inflation) in April. Some price watchers were inclined to dismiss the figure as “base effects”; prices of core goods like gas fell or stagnated from March to April 2020, for reasons we know well by now. So, one could take April’s 4.2% year-over-year jump in inflation with a grain of salt.

May’s numbers provide more clarity: prices rose in May by 5% year-over-year, the largest such increase since August 2008.

The big question on the minds of economists, policy makers, and real estate investors… is inflation here to stay?

In the neo-Keynesian model, inflation is determined by three main factors:

  1. Supply shocks
  2. Whether the economy is operating above or below capacity (i.e can we produce enough to satisfy demand?)
  3. Expectations: do consumers and price-setters expect prices to continue rising?

Taking a closer look at the first two factors, the U.S. economy does not appear in danger of sustained inflation. We are going through a period of acute supply shocks as sectors of the economy grapple with reopening and meeting pent-up demand. Car manufacturers are dealing with computer-chip shortages. Prices have temporarily recalibrated higher for airfare as travelers exuberantly dust off suitcases while flights remain limited. These pricing kinks should be worked out before too long.

Can the economy’s productive capacity meet demand in the longer term? There’s reason to believe. Since the 1970s — when sustained inflation last occurred — the economy has transitioned from manufacturing-dominated to tech-dominated. Global competition and the ascent of ecommerce have helped calibrate supply to demand for core consumer products. The Fed has a few more decades of learning under its belt, and is hopefully better positioned to temper inflation without impeding economic growth.

The third factor is tougher to pin down. Surveys have shown that consumers tend to overestimate the presence of inflation*. Here, again, it’s worth contrasting circumstances today versus the ‘70s, when inflation ran rampant. Price discovery and general economic information availability are better.

Sustained inflation could make life harder for real estate developers and investment firms in a couple of ways: 1) it could compel the Fed to finally depart from its policy of a bargain-basement benchmark rate, rippling through debt markets and increasing the cost of capital and/or 2) it could increase the cost of construction and operations inputs, tightening margins.

Fortunately, real estate provides some built-in hedges against inflation. Partly this is semantics, sort of like using a word in its own definition: the core CPI (the main measure of inflation) includes rent. In fact, rent makes up one fifth of core personal-consumption-expenditure inflation. Practically speaking it would be highly unlikely that prices for consumer goods and services would rise without a commensurate increase in rents.

Second, inflation typically accompanies strong economic growth, at least in the short-to-medium term. This means better paid workers competing for apartments, with retailers, office tenants (employers) and other amenities competing to serve those better paid workers. These are positive factors for real estate investors.

Indeed, appreciation of CRE assets tends to largely keep up with inflation, with Retail and Multifamily asset classes historically fairing best.

Rental income on commercial assets tends to provide a partial hedge, though not as robust as the relationship between appreciation and price increases. However, strong real estate operators (the kind that EquityMultiple seeks to work with) can control their own destiny in this regard. Here are some of the other strategies real estate investment firms and operators may pursue when expecting a prolonged inflationary period:

  1. Seek specific retail subasset classes, such as grocery-anchored, pharmacies, or cannabis, whose wares will generally keep pace with CPI.
  2. Pursue NNN leases and other rental models wherein operating costs are contractually passed along, at least partially (and sometimes entirely) to tenants.
  3. Bake in rent increases: indexing to the core CPI was common practice in the 1970s and beyond. Forward-thinking operators will consider introducing programmatic rent increases.
  4. Follow the trends: demand dislocations that were accentuated by the pandemic will continue. Knowledge workers will keep moving to “zoom towns” that offer more space and favorable tax regimes than gateway markets. Amenities will follow. So too should real estate investors.

The prospect of long-term inflation is not a trivial matter. But, should price increases persist beyond the near term, investors should rest easy knowing that commercial real estate is better equipped to weather inflation than most any other asset class.

Further Reading

MIT – Has Real Estate Been a Good Hedge Against Inflation?
Wall Street Journal – Fed Could Pencil in Earlier Rate Increase
Bloomberg – There’s a Big Divergence Developing in Inflation Expectations

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