Welcome to the inaugural issue of The Nextpert® Report, which offers insights and perspectives on current topics and trends that impact the business of real estate investing. In each issue of The Nextpert® Report, Andy Hochberg, Next Realty CEO and Managing Principal, will provide a synopsis of news reports covering key economic indicators, investing trends, and other topics of interest to our investors and friends.
Inflation and Real Estate Investment
Economic data released by the federal government continues to underscore the presence of increasing inflationary pressures. In recently released July figures, the inflation rate was 5.4%. This was the second straight month at that level which, in June, represented the largest single-month increase since August 2008. The increase was larger than expected by economists and business leaders, according to the consumer price index report published by CNBC .
Consumers feel the impact of inflation at the gas pump, grocery store, and when purchasing home goods and related services. As reported in an NPR story, businesses feel the pressure as employment costs, such as wages, salaries and other operational line items, increase the cost of doing business.
A real estate investor’s perspective on inflation is an interesting contrast. While both consumer prices and the costs of operating a business are increasing, banks and other lending sources continue to offer loans, often pegged to 10-year treasury rates, currently around 1.3%. This rate isn’t materially different than 12-18 months ago. Thus, from an investment perspective, inflation is not as much of a factor.
That landscape may be changing as increased inflation may cause an increase in interest rates. Upward pressure on operating expenses and capital improvements will decrease returns.
Shifting Paradigms in Real Estate Investing
Since the 1980s there have been two prevailing paradigms in real estate investing, each lasting approximately 20 years.
- The favorable investment climate, pervasive in the 1980s, when long-term debt was locked in at favorable rates. At the same time, short-term increases in revenues were achieved through regular/scheduled rent escalations. Inflation was hedged, value created.
- Since 2000 or so, the environment has changed. Interest rates and capitalization rates have both declined, creating increases in value even though income levels may have remained stagnant. Investments in real estate still resulted in successful yields.
Years of experience along with a changing economic climate suggest we are on the cusp of another shift. Interest rates are generally correlated to inflation. Currently, with the rate of inflation higher than interest rates, an imbalance has been created that has to equalize sooner or later. Interest rates are projected to increase, even though the Fed has not set any specific action or timetable. This in turn will cause cap rates to move higher. Depending on the asset class(es) owned, that can be a positive or negative development in a relative sense.
Certain asset classes, most notably parking facilities and hotels, have the ability to adjust rents on a daily basis, accommodating for shifts in supply, demand, and other market forces. Other assets have fixed rents that offer little if any flexibility unless lease terms stipulate annual escalations. In the middle of the spectrum are multifamily assets which typically reset rents annually as leases expire.
Over the course of the last 20 years, inflation has not existed at any truly meaningful level. As such, inflation hasn’t been an issue for most real estate investors. The next 20 years are likely to present a different scenario.
The view of the current inflation trends, and the impact they will have on real estate investments in the future, largely depends on your investment thesis and whether you:
- are investing on a long or short term horizon,
- are investing for income or growth and appreciation and/or
- have a tolerance for risk.
There is no single approach that counters inflation regardless of your investment profile. We believe the following factors contribute to hedge inflationary pressures in performance of real estate assets:
- ability to adjust revenues frequently,
- ability to attain favorable long-term financing,
- ability to acquire product types that have high replacement costs.
The principles of a sound acquisition philosophy can be executed regardless of the fiscal policies or inflationary pressures that may exist at any given time. For example, in the current scenario where the rate of inflation is higher than interest rates, we believe it is prudent to acquire existing properties where we can adjust rent quickly, secure or refinance long-term debt, and find properties where replacement costs leave the asset in a strong competitive position.