Inflation is coming! Depending on how and when you consider inflation, it has been very bad (think Jimmy Carter presidency) or very desirable (recent goal of Janet Yellen). How do we know what the right time and amount is, since it’s both bad and good? How will it help or hurt us in our real estate businesses? Well, it’s all about balance, like most things.
There are many definitions of inflation, and little need to review them here. A precise one refers to it as the depreciation in purchasing power of a flat currency, often resulting in the appearance of rising prices. In other words, it’s just what your think, stuff gets more expensive. What’s more important is that there are many measures of inflation. The Fed reviews most, relying in large part on the Personal Consumption Expenditures produced by the Department of Commerce, the Consumer Price Index, and Producer Price Index issued by the Department of Labor. From these indices, the Fed determines what the annual range of inflation is, with 3-4% considered benign.
Just as there are good and bad ranges of inflation, there are good and bad effects from inflation. Here is a summary of bad effects:
• Inflation erodes purchasing power – Inflation is a decrease in the purchasing power of currency. For example, as you may recall, a Porsche in the 1960’s cost around $5,000. While the 2017 model has been improved and is more costly to produce, it will now cost you well over $100,000.
• Inflation can cause more inflation – The urge to spend cash can further boost inflation, thus causing an unnatural acceleration of inflation, creating a vicious cycle. As demand for goods increases, available supply can diminish causing even higher pricing.
• Encourages spending – During inflation, when purchasing power is declining, spenders may buy or invest earlier to get the benefit of their current value of cash. For businesses, it may mean making capital investments that under different circumstances might be put off till later. On the flip side, that could also have positive impacts for those businesses, thus showing that not every inflation consequence is perfectly bad or perfectly good.
• Inflation raises the cost of borrowing – With low interest rates, as we have seen for the last decade or more, borrowing is obviously cheaper to start a business, hire workers or build a building, generally stoking inflation in turn. By raising interest rates, central banks can put a damper on these “animal spirits”.
On the positive side:
• Inflation can also lower the net cost of borrowing – While interest rates may increase as above, inflation can also cause the net present value of the debt to decrease. The principal payments effectively become “lower value” in inflationary times. Thus, the future debt you may pay back is “less” than what you anticipated.
• Increases growth – Except for the potential increase in interest rates, inflation can spur spending, as mentioned before. Increased spending has a positive impact on businesses providing goods and services. This may also tend to put more people to work, for even further growth.
• Weakens or strengthens the currency – I’ll end with a bad/good example that shows the relativeness of impact. Depending on whether you are an exporter or importer, inflation benefits or hurts you. With weaker currency, your goods are cheaper and easier to export relative to higher currency countries. The opposite is true of a strong dollar. We are able to buy more imports with that dollar, but produce fewer exports affordable to other nations.
I promised I would suggest what will be good or bad for real estate with our anticipated inflation. But as you see, it depends. Clearly an erosion of purchasing power due to the lower value of cash combined with higher interest rates will make new projects more difficult in the future. Further, if the cycle of spending increases due to consumers buying more sooner, things will get more expensive faster. On the other hand, inflation may push the cost of real estate higher, faster, thus increasing value in the asset, while also reducing relative cost of principal payback. If inflation increases growth, there will be more consumers, potentially more jobs, and potentially more demand, all good for owners of real estate assets.
Complicated, yes! It depends on where you are in the real estate cycle. Those who borrowed early at low rates will benefit from fixed low interest costs, depreciating value of principal payments, appreciation in asset value, etc. Those developing or investing into an interest rate increasing environment will have a harder time. Best advice, spend some time digging deeper into this complicated subject to see where you stand.
Daniel Calano, CRE, is the managing partner and principal of Prospectus, LLC, Cambridge, Mass.