United States Secretary of the Treasury, Janet Yellen, made a surprise announcement in early June when she did something few inside the Beltway ever do. She admitted she was wrong.
“There have been unanticipated and large shocks to the economy that have boosted energy and food prices and supply bottlenecks that have affected our economy badly that I didn't—at the time—didn't fully understand, but we recognize that now," the former chief of the Federal Reserve told CNN.
SIOR members couldn’t agree more. When asked how inflation is being handled, the general answer is, as Grant Pruitt, SIOR, puts it, “Not well. I’m not a politician,” says the Dallas-based president and managing director of Whitebox Real Estate, “But I am a realist and a data guy, and when I see fuel, energy, and transportation costs way out of balance, there’s clearly a supply issue, which is oftentimes encumbered by political gain.”
And apparently by long-standing monetary practices. “Inflation isn’t something that just happens like a natural disaster,” says Bjarne Bauer, SIOR, managing partner, Commercial Real Estate Transactions, for NAI Sofia Group in Shanghai. “The single most important factor creating inflation was the amount of liquidity added to the system.”
"Inflation isn’t something that just happens like a natural disaster. The single most important factor creating inflation was the amount of liquidity added to the system."
His firm’s March newsletter expands on that theme, reporting that between 2011 and 2021, the amount of U.S. money in circulation doubled from roughly $9 trillion to $19 trillion, with similar patterns occurring in the Euro-Zone and China. “As money supply increases,” says the report, “there is typically a time-delay of months or years before it manifests as inflation. It is possible that high inflation rates recorded in recent months are just the beginning of this ‘correction’ of the value of money and goods.”
Whatever the encumbrances, what has been called the worst inflationary period in four decades apparently took an April breather, “with the 12-month figure falling slightly to 8.3 percent from 8.5 percent in March,” states Forbes Advisor. But there’s a cloud inside that silver lining, and writer Taylor Tepper points out that a pause is not a peak. Those numbers “merely suggest that price gains have plateaued for the moment. It would take more than one month of moderation in [consumer price index] data to say that inflation has peaked.”
In fact, moderation might not come around until we flip the annual calendar, possibly more than once. “If we did hit our peak,” says Pruitt, “we should see that taper off over the next 24 months or so, to maybe 5% by the end of the year, then around 3% for 2023 and then normalize past that. As long as we don’t slide into recession, that’s pretty realistic.”
As SIOR Report stated in its Q2 edition,3 the current economic picture is further clouded by more than just wrong-headed decisions inside the Beltway, issues such as geopolitical unrest, a still-snarled global supply chain, and a major shakeup in hiring dubbed “The Great Resignation.” All of these factors lead, directly or indirectly, to increased costs.
Larry FitzGerald, SIOR, calls the rising cost issue a perfect storm. The executive managing director of Newmark in McLean, Va., throws into the mix “changing dynamics in consumer buying and the data center demand taking much of the inventory of existing or potential industrial development sites.
“Industrial rents have probably gone up 20-30% in the last 24 months,” he continues, “causing a lot of sticker shock in both renewals and new leases.” But pinning that jump—or the skyrocketing cost of fuel—on inflation alone becomes a fool’s errand. (At the time of this writing, AAA put current diesel fuel costs at $5.74 per gallon, compared to $3.20 a year ago.)GRIN AND BEAR IT
There is a grin-and-bear-it aspect to inflation. Personally, FitzGerald reports of a new home purchase for himself that imposed a mortgage rate “a point or two higher than it would have been earlier this year.” And, as all of our speakers attest, he’s feeling the “pain at the pump.”
Interestingly, on the professional side, they also report of only minor burdens. So far, at least. “I haven’t seen a significant impact yet on my business,” he says, “but it’s starting to impact investors and renters, who are pausing a bit, acting not quite as aggressively as they might otherwise.”
Underwriting criteria have become a little more stringent, he adds, “because now you’re trying to forecast not only your rates on debt but also your exit cap. If you’re doing a 10-year pro forma, what could you project on that asset’s sale? That’s a huge unknown right now.”
With all the talk of inflationary woes, it should be mentioned here that sometimes, depending on your role, it can bring—shall we say it?—good news. Bauer, for instance, is also a property owner, primarily of apartments, and as such, he says unabashedly, “it does benefit me greatly.”
This is due to the inverse dynamic of money value and property value—as one goes down, the other rises. He’s quick to add, however, that he and the clients his team advises have loans with long-term fixed interest rates. For investors that have floating-rate loans, most of the capital gain will be eaten up by higher rates.
Much like the U.S., the past two decades in China have seen most property values “grow like crazy,” says Bauer. But the proportions are very different. While in the U.S. values nearly tripled, “which is wild enough, China literally saw a 10-times growth in just 20 years.”
PLAYING THE LONG GAME
As mentioned in the Q2 Report, passing costs onto customers and clients is one inflationary relief valve, although it opens only so wide and only for so long. “With the current labor shortages,” says FitzGerald, “we all have to pay higher wages, and rents are going up, as are insurance premiums and fuel. But there’s a fine line that’s easily crossed when you start passing these costs onto your customers.”
Profitability is a function of either increased revenues or lower operating expenses. Here, as commercial advisors, SIOR members can help their clients handle the inflationary challenge, at least by handling the latter.
"Profitability is a function of either increased revenues or lower operating expenses. Here, as commercial advisors, SIOR members can help their clients handle the inflationary challenge, at least by handling the latter."
Pruitt, the self-attested data guy, leads understandably with accurate information: “I make sure our clients understand what the data says and make sure we’re appropriately forecasting for the long term.” He compares short-term strategies to day trading in stocks, because all markets “go up and down, and based on the data, we have a pretty good idea what that looks like.”
While the pandemic hit us all by surprise, Pruitt says experience has provided a “decent playbook for this environment.” Assuming an apolitical Federal Reserve, one that “acts independently and truly is doing what they believe is best for the economy, we are in a fairly decent place.”
What? Yep. He points to the broader picture, which takes in extremely low unemployment, despite the Great Resignation, as well as the Fed’s focus on the issue, with its plan for slight interest rate adjustments throughout the year, however late to the party that might be. “They know what has and hasn’t worked. We have better stewardship than we ever did a decade ago.”
FitzGerald, too, puts his faith in the long game. “If I’m forecasting costs and rents over the next five years, my crystal ball indicates continued growth,” he says, “probably not at the same rate as the past 12 or 24 months, but they’ll continue to go up.” So, his advice to tenants is to lock in longer term rates today, “for as long a term as you feel comfortable with.”
He adds that the same is true on the buy side. “Banks are flush with capital,” he says, “and they would love to get it out, especially in the current higher-rate environment. If you have access to that capital, lock in that rate today.” Yes, you’ll be paying more for debt today, “but if they’ll give you a five-to-10-year lock, go for it.”
There are situations, of course, that indicate shorter-term strategies. “That’s an operational risk you’re taking on,” he warns, “and you’ll likely be looking at a higher rental rate environment.”
Bauer adds frankly that people who are blindsided or hobbled by inflationary environments such as our current situation are playing a fool’s game. “If a company had a lease for 10 years, and during those 10 years the government doubled the amount of money in circulation, the logical result would be each dollar being worth only half. That idea, somewhat shockingly, comes as a surprise to many people.”
That said, Bauer aligns with his SIOR colleagues and advises clients “to take a mid- to long-term view,” locking in escalations to minimize sticker shock.
We may or may not have faith in the Fed. But the long-term strategy being counseled by the professionals interviewed here are based on a more essential dynamic, as Bauer points out: “It is the fundamentals of our business and real estate as an investment that counts the most.”
Bjarne Bauer, SIOR
Larry FitzGerald, SIOR
Grant Pruitt, SIOR