A Strong Recovery Would Likely Outweigh Expected Short-Term Price Increases
As the third COVID-19 relief bill made its way through Congress, a new concern dominated conversations among economists: inflation. Massive stimulus packages that more than bridge the current output gap mixed with a 25% increase in the money supply has some concerned over expected inflationary pressure that hasn’t been seen in a generation.
The 10-year Treasury rate has jumped 60 basis points since the beginning of 2021 as new supply from government spending and inflation concerns have rolled through the market. Disrupted supply chain problems internationally could also put pressure on price increases.
In the short term, there is good reason to believe inflation will run significantly higher than it has over the past 10 years. For commercial real estate, this could lead to lower real returns on income, as net operating income is somewhat sticky. Continued increases in construction costs for both material and labor would also be a problem for developers.
But commercial real estate is a longer-term investment and inflation is unlikely to run out of control in the next 10 years. For investors concerned about the inflationary effects of the new stimulus, the benefit of a strong economic recovery out of the pandemic crisis should far outweigh the risk of some transitory price increases. The real risks to commercial real estate asset values — Fed rate hikes and rising bond rates — are likely still a few years out and expected to remain low by historical standards.
For the short-term view on where inflation might go, the risk is almost completely to the upside. The argument for higher inflation primarily comes from what economists refer to as demand-pull inflation. Government transfers of cash to lower-income households, along with some additional investments in education and local government, push aggregate demand to unsustainable levels. When that demand outstrips supply at a given price, the economy undergoes inflation.
Currently, there is an estimated 3.5% output gap. Including the 2% expected growth in potential gross domestic product, the U.S. economy would need to grow roughly 5.5% next year just to reach a point of neutral inflation pressure. Given a continued strong recovery, Oxford Economics is currently projecting GDP growth of 7% in 2021, which would push inflation to 3%, but for only an expected brief period.
After a short-term bump, Oxford Economics is forecasting inflation levels will return to the Fed's 2% inflation target by 2023 as the effects of the pandemic and government stimulus wear off. The bond market seems to be in agreement, with five-year break-even rates, which reflect the bond market's implied average inflation rate over a given period, running 50 basis points higher than the 10-year rate, marking the first time the short-term and long-term rates have inverted since 2008.
Break-even rates have increased dramatically in the first quarter of 2021, but still fall within historical norms. For commercial real estate investors, a brief increase in inflation to 3% could squeeze real income returns briefly, but not significantly.
While the aggregate demand argument works well for a short-term bump in prices, it is less effective for explaining why prices will continue to spiral long term. Higher unemployment benefits for six months and $1,400 one-time payments to consumers do not provide years of fuel for an overheated economy. Typically, for long-term inflation risk we look at expectations, in this case indicated by the break-even rate, which remains well within historical norms.
To qualify both the long-term expectations for inflation and short-term (five-year) projections, the risk is mostly to the upside. Economists have become exceedingly optimistic about the U.S. economy’s future, and rightfully so. Spending packages that focus on a bottom-up approach to stimulus, mixed with a stronger-than-expected labor recovery, should help push economic growth as the U.S. economy starts from a strong base.
All of this suggests higher long-term inflation than the last cycle but still well within historical norms, as deflationary pressures such as historically weak demographic growth, an aging population, automation and income inequality have not disappeared, despite some short-term reprieve for low-income households.
If we believe inflation is not a major concern, where is the risk, or opportunity, for commercial real estate? The answer lies primarily in how much conviction Federal Reserve Chairman Jerome Powell has in keeping rates low in the face of rising prices and the bond market’s appetite for new Treasurys.
The Fed has committed to keeping rates low, at least through the next year, and even went so far as to change how the Fed responds to above-target inflation by aiming for a long-term average as opposed to raising rates at the first sign of rising prices.
The idea is to allow inflation to run above the 2% target for some time, as economists noticed many economic gains in low-income and minority communities did not occur last cycle until the economy was at or near "full employment." Even if the Fed did begin to raise interest rates, there is some room before commercial real estate starts to feel the heat.
Investors fled to safety in 2020, leading to a dramatic decline in 10-year Treasury yields, while commercial real estate capitalization rates have held steady. The resulting spread between cap rates and Treasury yields widened to 560 basis points by the end of 2020, well above the 460-basis-point historical average spread since 2010.
That above-average spread would normally tell us commercial real estate is relatively undervalued. However, the speed at which the pandemic crisis unfolded and is now recovering means current ultra-low rates will be relatively short-lived. CoStar's current projection forecast is calling for cap rates to remain relatively steady. If forecasts of relatively tame inflation in the long term are correct, and the Fed sticks to its guns on allowing inflation to run hot for some time, a flat cap rate for the foreseeable future is the most likely outcome.
Even if rates do rise, the Fed considers an interest rate of 2.5% to be its “neutral rate,” what it considers to be neither stimulating nor creating a drag on economic growth. While 2.5% would be the highest level that interest rates have reached in over a decade, historically that is still quite low and unlikely to occur until the mid-2020s.
For commercial real estate investors, flat cap rates are not terribly exciting, but they can inform strategy. Tier 1 core markets, such as New York and San Francisco, will continue to be targets of institutional investors for their relative stability. Meanwhile, growth markets in the Sun Belt that generally offer higher yields will provide more opportunities for those investors seeking continued cap rate compression.
If inflation does come back stronger, there are advantages as well, especially in property types with shorter lease terms and strong demand such as the multifamily and industrial sectors. Strong demand should continue to support real value growth in these sectors, while shorter leases can allow landlords to adjust faster to an expected higher inflation environment.
Regardless of whether inflation is 2% or 3%, the push in prices is expected primarily to be driven by strong consumer demand across the income spectrum and increasing optimism, something that should be a positive for all commercial real estate investors.