We were expecting that the Fed’s meeting on Aug. 27 would go as a matter of course, but instead the Fed announced a profound philosophical shift by stating it would no longer focus on keeping the inflation rate at 2 percent or below. That had been the target rate officially since it was set by Ben Bernanke in 2012. Unofficially, Fed policy had focused on fighting inflation since Paul Volcker was appointed Fed Chairman in 1979 during a time of soaring prices. Volcker subsequently tamed the beast that existed within inflation. On Sept. 16, the Fed indicated it will probably keep short-term interest rates near zero through 2023, sending a message to the market to not worry about the old paradigm of needing to fight the inflation demon at all costs.
Will this be good or bad news for commercial real estate?
The Personal Consumption Expenditures Index is the Fed’s preferred measure of inflation, and historically it has run a bit higher than Consumer Price Index inflation. But while we wait for August’s PCE numbers, the CPI data released on Sept. 11 showed an uptick to 1.3 percent (annual rate seasonally adjusted) in August, compared to 0.7 percent and 1.0 percent in June and July, respectively. The CPI calculates inflation by comparing average price changes over time on a basket of goods. Currently, the basket of goods consists of over 200 categories. Prices are weighted based on utility, or the importance of the item, for consumers. One should question the relevancy of the basket of goods, particularly in today’s environment, and the future cash flow outlook for various commercial real estate property types.
Looking at headline inflation masks an important distinction for commercial real estate cash flow forecasters, however. Cash flow forecasters typically apply a general inflation rate in the range of 2 percent to 3 percent to the increase for both revenue growth and expense growth, but either of these can have different drivers relative to future increases. The general inflation estimate approach might be appropriate during normal times. In these decidedly abnormal times, however, we need to dust off our economic books and understand cost-push vs. demand-pull inflation, and how they affect commercial real estate from the expense side and income side in separate ways and often not in tandem.
The Push and the Pull
Cost-push inflation is generally more applicable to expenses. Prices are pushed higher as a result of increased costs such as labor and raw materials (think of the record-high and steadily increasing construction costs). Cost-push inflation can also lead to higher maintenance costs, insurance premiums and property taxes. The latter expense is the largest and most dangerous demon to the income performance of commercial real estate, and significant increases are becoming much more likely as states and municipalities are running big budget deficits.
Demand-pull inflation is essentially the result of demand outpacing supply. When demand outstrips supply, this type of inflation pulls up rents to match market conditions and can happen when there is low inflation―just think of rent spikes. However, the other side is when excess supply outpaces demand and revenues fall, a situation faced now by property types such as hotels and certain retail assets.
The different drivers of inflation call into question the ability of commercial real estate to serve as an inflation hedge. Oversupply wasn’t a major issue heading into the pandemic, like we had in the 1990s, but concerns remain about corporate liquidity, employment, wage growth and consumer spending. We have already seen cost-push inflation on the expense side, but it remains to be seen how the demand-pull inflation or deflation of rents play out as we bridge ourselves to reach the other side of COVID-19.
Inflation will probably even out to about 2.5 percent (2.0 percent to 3 percent range) over the next 20 years, but putting rigor on the estimate of cash flows for the next three years will determine whether investors pick winners or losers. Will the estimate of increases for revenues and expenses based on a generic inflation figure be the genie in the bottle for commercial real estate that we hope for―or will it be a wolf in sheep’s clothing? We know in the commercial real estate world that a lot of the revenue outcomes depend on supply and demand characteristics, but we seldom link that insight to the revenue forecast. Equally, we know that not all expenses, property taxes and insurance will match the government-calculated CPI.
During these times of extreme uncertainty, accurately forecasting revenues and expenses to achieve an NOI estimate is paramount. Cash flow is the driving force of fundamental analysis vs. technical analysis; it supports the valuation marks for the private commercial real estate industry and is used to gauge the asset values of public REITs. Cash flow forecasters need to think carefully about developing rent and expense forecasts―not only in establishing the base figure but how much they escalate that figure over a typical discounted cash flow period of 10 years, which is the commercial real estate industry standard.
Ken Riggs, CFA, CRE, MAI, FRICS, CCIM, is president of RERC, a SitusAMC company.