Inflation and real estate
By: J. David Chapman/February 22, 2018
Almost every newspaper ran an article last week on looming inflation and the resulting concern in financial markets and investors. These articles were sparked by a 0.5-percent increase last month in consumer prices. The increase was led by clothing and insurance costs. Although they recovered, this report helped trigger investors to dump stocks and bonds.
The most significant factor influencing inflation is the growth rate of the money supply, specifically when the nominal supply of dollars grows faster than real demand to hold dollars. However, the effect of supply and demand pressures in the economy influenced by the relative elasticity of wages, prices, and level of interest rates cannot be ignored and may actually be more influential in the short term.
Inflation has been largely absent for most of the past decade; however, under this new administration we have seen the largest wage increases in eight years caused by low unemployment and a shortage of workers. Although it is true that we saw a 1.7-percent increase in clothing costs, 1.3-percent increase in auto insurance costs, and 5.7-percent increase in gasoline prices, the overall 1.8-percent increase in core prices is still below the Fed’s 2-percent inflation target.
Commercial real estate, as an asset class, is a hedge against inflation, meaning that it can help offset the impact. The theory behind commercial real estate’s hedging characteristics has to do with rent adjustments. Typically, robust economic growth results in higher inflation, and therefore landlords/owners of commercial space expect more rent growth.
The financial crisis and resulting recession created pressure on both inflation and commercial rents. Although empirical evidence suggests that rent growth should be correlated with inflation over the long term, the changes in recent rent levels largely depend on short-term supply and demand fundamentals and lease terms. After the recent recession, we saw rents across all property categories decline significantly faster than the inflation index. However, partially because of the low inflation rate and partially because of good economic recovery, we have now seen commercial real estate rent growth outpace the inflation index.
If we do see increasing material and labor costs needed to reproduce existing assets, this will only help property values. Prudent property managers will have already calculated anticipated inflation into multiyear cash flow projections.
Dr. J. David Chapman is an associate professor of finance and real estate at the University of Central Oklahoma (jchapman7@uco.edu).