Sassy Baristas Might Like Inflation, CRE Investment Managers Should Not

Inflation is not good for real estate. Inflation is not good for anybody. That line of thinking runs counter to the popular notion in our industry that inflation can benefit real estate. This notion equates some long-term resistance to value erosion from inflationary trends as a feature that will benefit performance. There are more pernicious ways that inflation undermines performance that one must consider, however.

I used to get my coffee in the morning from a tattooed barista who lived in Bushwick and would tease me in a friendly way that all of us financial sector workers are going to be taxed heavily to return New York to the Worker’s Paradise of yore. The vision was one of greater prosperity through taxation. Would greater taxation lead to prosperity for real estate investment? Few in our industry would make that point.

Demand Destruction

Fundamentally, inflation is a tax on consumption. Every dollar spent does not go as far when inflation bites into consumer spending power. Eat into the growth of consumer spending power and one will see less potential to charge rents to retailers and apartment residents, among others. In the most extreme cases, households and businesses will opt out of the rental markets and buy instead of renting to protect themselves from ever-escalating rents.

Managers touting the notion that inflation is good for real estate should take note of the long-lived impact of the inflation experience in Latin America. Hyperinflation in the 1970s and 1980s changed the expectations of consumers and businesses in countries across the region. When one is in a high inflation environment, the mindset changes to a perspective where purchases and spending today are preferred to higher costs in the future. The impact on behavior however lasts for decades.

If Inflation is Good for CRE, Everyone Should Love Investing in Brasil

Sources: OECD, Creative Commons Image

In Brasil for instance, inflation hit a high of 6821% annual growth in 1990 followed by a spike to a 4924% annual pace of growth in 1994. Following these periods of hyperinflation, price growth retreated to far more manageable levels from 1997 forward. There were some periods of elevated inflation that would seem untenable in the developed world with a peak rate of 17% set in 2003. Inflation in Brasil is only up to a 12% pace so far in 2022. Tenant and investor behavior that developed in the hyper-inflation period of the late 1980s and early 1990s continued into the period of “modest” inflation seen over the last ten years. This higher pace of inflation is one factor limiting the size of the investible universe in Brasil and Latin America generally.

The professionally managed commercial real estate market stood at a $11.4 trillion value in 2021 according to an annual study by my research colleagues at MSCI. The total value is likely higher considering all of the smaller, non-professionally managed assets in the world. All of this space though exists for a simple purpose, commercial real estate is just a box where the economy lives.

The bigger the economy with more industrial production, tourism, consumer spending, and office workers collaborating in the knowledge economy, and the more tenant demand there will be for commercial real estate space. The market for space equilibrates the potential demand from the economy to a realized demand in terms of net absorption based on factors such as the price and availability of space. That market for space is tied to the market for commercial real estate investments over a long horizon with investors placing a value on all of that potential demand from tenants. Given all these linkages, over a long horizon the amount of deal activity in a market should tie back to an element of the size of the local economy.

Larger economies should have more liquid investment markets over time just from a numbers perspective. A larger economy will mean a need for more physical assets which will simply produce a larger target set for investments. Looking at the average annual deal activity over the ten years to 2019 in South and Central America versus those in the U.S. and Canada, it is clear that there is less deal activity relative to the size of the economies Latin America than there is in North America.

Relative to their Size, Latin American Countries Should See more Deal Activity

Sources: MSCI, BEA, IMF

Making comparisons across countries can be difficult with exponential growth in sizes between local economies so the chart looks at both the average annual deal volume over the ten years to 2019 and the size f the local economies in 2019 in logs to show a linear trend. Additionally, currency comparisons for economies can be a challenge at times as a straight currency conversion of GDP ignores the fact that a dollar of spending can go further in some developing economies than in the developed world, so GDP is compared on a purchasing power parity basis. The apartment sector is not as fully developed in Latin America as in the U.S. so the chart looks only at deal volume for transactions priced $10m and greater in the office, industrial, retail and hotel sectors. Last, the U.S. economy is just so big, that the chart splits up the economic and deal activity across 50 states and the District of Colombia as the size of these local economies are comparable to countries in Latin America.

On a purchasing power parity basis, the economy of Brasil was slightly larger than that of California in 2019: $3.2 trillion versus $3.1 trillion. Despite that larger economy, the commercial real estate deal volume in Brasil was a fraction of that seen in California over the ten years to 2019 averaging only $4.2 billion per year versus the average $47.5 b in deal activity in California. The legacy of inflation expectations plays a role here.

Faced with inflation rising at triple and quadruple digit rates in the 1980s and 1990s, consumers and businesses opted out of the leasing markets. The office markets of S?o Paulo and Rio de Janeiro for instance are heavily driven by strata title tenancies where businesses and retailers will own the spaces occupied rather than renting. By owning these spaces, firms protect their balance sheets from triple and quadruple digit inflationary shocks.

With slightly higher interest rates over time than in North America as well, cap rates are higher and every peseta of income on a property will not drive as much property value as seen up north for a comparable property. Because of the smaller asset set and deal sizes, many transactions will fall below the $10m threshold where it is possible to track deal activity globally.

Other factors can help explain the lower levels of deal activity in Latin America for every dollar of economic potential. There are different tax regimes which can alternatively punish or reward capital gains. Colleagues active in the accounting world simply could not put a finger on the differences in tax rates for me citing vast differences in regulatory burdens across countries as to what is taxed whether it be sale prices, income or some mix. Brokerage professionals active in the region also note that asset managers in the region are simply hesitant to sell citing a view that once they are in cash, they are exposed to more risk. The legacy of higher inflation expectations could be argued to be driving both of these cases though the clear impact of inflation is seen in the dominance of the strata title market and financial considerations.?

Financial Burdens

Beyond the demand destruction through the consumer spending channels for real estate, inflation poses a challenge for the valuation of assets though the financial channels. Commercial mortgages originated in 2021, saw an average 3.64% coupon rate for 7/10 fixed rate products. Into May of this year, this rate had climbed to 5.21%, an extra 157 basis points. This surge in rates also took commercial mortgage rates higher than the average 4.64% seen from 2014 to 2018.

Commercial Mortgage Rates Surging on Inflation Fears

Sources: MSCI, Freddie Mac

As mortgage rates climb on inflation fears, property values can face challenges. Suppose one bought a logistics asset at a 4% cap rate with short term debt in 2021 at a 3.68% coupon rate. That 32 bps of spread between the cap rate and the mortgage rate does leave some room for free cash flow outside of debt service. Into 2023 as such a short-term loan reaches maturity, what happens when that 3.68% coupon rate is pushed up to 5.25%?

What if the commercial mortgage rates climb even higher? The 30 year fixed residential mortgage rate published by Freddie Mac is updated weekly and while the asset classes are different, over time, the rates on fixed rate mortgages for both apartments and commercial properties do move with this series. For apartments there has been a roughly 40 bps spread to the Freddie Mac series from 2010 to 2018 while there was a 75 bps spread for commercial mortgages. With the Freddie Mac series up to 5.11% through August, is something closer to the 6% level in sight for commercial mortgage rates?

If property income did not grow enough in the interim to compensate for the higher debt service faced as loans mature, someone will take a loss. Yes, many investors have been underwriting strong income growth assumptions thinking that the either the rebounding economic environment will continue to grow rapidly or that inflationary pressure itself will push up income. The relative aggressiveness of those income growth assumptions will be a key point to survival as low rate mortgages mature.

Pitches by some syndicators suggest a notion that if inflation is increasing that one might simply raise rents to compensate for the increases. These pitches reflect a lack of understanding of how prices are set in the rental markets. Property owners are, to some degree, price takers in the market. It is the imbalance between the supply of space and the tenant demand that determines appropriate rent levels. A goal-seek solution in Excel to solve for a rent level that gets an investment to the IRR pitched to investors will not actually get one that rent. Ask too high of a level relative to what the market will bear, and occupancy will crash.

This sort of loan maturity induced shock will not matter much for some borrowers and investors. An institutional player like a sovereign wealth fund pursuing low leverage deals with long-term holding periods will not face an immediate reset in debt costs. But that marginal borrower who had turned to a debt fund for a short-term loan at a high LTV just to get a deal to work at the low cap rates seen in 2021 … it does not matter how heroic their income growth assumptions were if these never materialize.

Be Careful What You Wish For

The economy and property investment do best when we are in a Goldilocks situation for inflation: not too hot, not too cold. The market has been responding to a too hot situation in 2022 which stands to place pressure on property valuations. As opposed to a barista accidentally giving you an extra-hot drink though, market participants cannot simply wait a minute or two for things to cool down.

Managers thinking that inflation will simply allow them to raise rents are likely to be disappointed. Tenants will adapt their behaviors and try to avoid rent increases. Either through economizing on space, moving to lower cost locations or simply opting out of the rental markets, businesses and households will react to ongoing price increases in ways that will not support ever increasing property income.

Unless mortgage rates suddenly reverse course, there will be challenges hitting the market in 2023 as short-term loans originated to highly leveraged buyers in 2021 mature. Even if income did continue to grow, and even if an investor did not use high octane debt to buy a property, the fact that others pursued such behavior can place a cloud over valuations as debt costs increase for the broader market.

Under Chairman Volcker, the Federal Reserve bank moved aggressively to contain inflation as well as consumer and business expectations around inflation. Had these leaders not acted, perhaps businesses and consumers would have opted out of the rental markets to the same degree in the U.S. as people had in Latin America. The pain that comes with fighting inflation today may be better for CRE investors than the long run lower liquidity U.S. markets would experience if inflation expectations got out of hand.

This article leverages data from MSCI at https://www.msci.com/ where subscribers can acces the underlying data. Any opinions expressed are mine and not those of MSCI and should not be construed as investment advice.