It’s nearly impossible to consume a piece of economic news lately without hearing the word inflation. But every time I hear it I have to remind myself: there is no such thing as inflation. It’s not that it doesn’t exist, anyone who has bought pretty much anything in the last few months can tell you that it certainly does. It’s that there is no one, perfect definition for it. Even economists, with their burning desire to define every economic force, have had an evolving view of what inflation is and what it means for currencies and the people that spend them.
The idea that the price of a good or service increases over time is as old as economics itself. Originally, it was thought that the value of something was tied to the inputs it takes to produce it, but as the economy globalized, and British colonies borrowed money to fund their battles for independence, it started to become clear that other forces were at play. The term “nominal value” was created to help us understand the interplay between “real value” of a product and the currency it was being purchased with.
Adam Smith, a Scotsman considered to be the father of modern economics, explained it like this in 1776: “The real price of everything […] is the toil and trouble of acquiring it. The same real price is always of the same value; but on account of the variations in the value of gold and silver, the same nominal price is sometimes of very different values.”
The next big shift in thinking about prices and value came from debts from a different war, this time the American Civil War. The Union government had issued a type of promissory note called “Greenbacks” to fund their war efforts against the Confederacy and the time had come to pay them back. There was a battle between debtors and creditors about which price of gold to use for the exchange. It was this time that the term inflation started getting thrown around. It was initially used to describe a change in the value of a currency relative to the amount of precious metal that constituted a nation’s money.
Eventually, the distinction between “currency” and “money” blurred. Another foundational economist from the British Isles named John Maynard Keynes helped spearhead the idea that inflation was more about the actual purchasing power of money than its relationship to precious metal. It was then that modern economies started unhitching their currency to gold and letting the supply and demand for their money become the only drivers of exchange rates. Keynes also posited that inflation caused by governmental borrowing is in fact a form of taxation and thus should be handled deliberately and prudently by governments’ central banks.
But even as economists got a handle on the complex and multifaceted definition for inflation, it became clear that calculating inflation would require a lot of assumptions to be made. Inflation is the decrease in the purchasing power of a unit of currency over time and that number changes a lot depending on what is being purchased. Everyone in the world has their own unique spending habits therefore everyone in the world has their own unique equation for inflation. Economists have tried to solve for this by creating price indexes adding up what a typical “basket of goods” for an average household would look like. These are the numbers that get thrown around on the news when we want to reduce the entirety of the conversation around inflation to a sound bite that fits in between traffic and weather reports. But they are not the entire story.
Inflation has been around for so long that most people take its definition for granted. This same sophomoric understanding of inflation can infiltrate real estate at times. “Real estate is a hedge for inflation,” is an adage often regurgitated as it were maxim. But if there is no “inflation” then how can real estate be a perfectly correlated buffer against it? In order to reexamine inflation’s effect on real estate, I had to first come to terms with what inflation really means and what kind of inflation we are experiencing at the moment.
Every two years the Bureau of Labor Statistics compiles a weighted list of goods that each household spends on. The weights of each category change over time to reflect current household spending habits (or at least current two years prior, when the survey was taken). One of the most commonly used indexes, The Consumer Price Index For All Urban Consumer, allocates fourteen percent of a household’s annual budget to food, seven and a half percent to energy, and seventy-eight and a half percent to everything else. These numbers are especially important right now because we are currently experiencing an inflationary period unlike any other.
The value of a currency is, much like any other product, pegged to its supply and demand. Putting new money into circulation can help fund a government’s growth but can change the value of a currency as a result. The effect of supply and demand on the U.S. dollar is being tested like never before. The federal government has significantly increased the supply of money to help alleviate the economic stress of the pandemic, around forty percent of all of the money ever printed by the U.S. Federal Reserve was done in the last year and a half. Normally this would have a devastating effect on a currency’s exchange rate, but that has not happened. The dollar has remained steady against other important currencies like the Euro, even gaining a bit in the last few months.
One reason for this is that the rest of the world has been printing money as well. Another reason is that the value of the dollar is also tied to the world’s appetite for America’s debts, in the form of treasury bills, which are still seen as one of the least risky investments. America, despite its problems, is still seen as a safe haven for capital.
Nonetheless, Americans are seeing prices climb. This has less to do with global currency exchange rates and more to do with the cost of production; real prices are rising, not nominal prices. The rise of prices isn’t spread evenly across our imaginary basket of household goods, either. Certain items have seen prices skyrocket due to production shortages and supply chain slowdowns. For example, right now about a third of the inflation being felt today is due to the increase in the price of cars.
“Housing inflation is part of our CPI and so what could be mistakenly considered a detriment to real estate is actually a sign of growing real estate rents and property values.”
The thought is that inflation will weigh on the profitability of buildings, as both their expenses and their investors’ opportunity costs will rise because of it. But trying to read the future with the CPIs that get thrown around on the news might not be the clearest of crystal balls. “A CPI, especially ones that exclude utilities, are not well designed to help understand the effect of inflation on a real estate portfolio,” said Andrew J. Nelson, real estate economist and one of the authors of ULI’s annual Emerging Trends report. He explained his reasoning, “housing inflation is part of our CPI and so what could be mistakenly considered a detriment to real estate is actually a sign of growing real estate rents and property values.”
Taking the time to create each property’s own basket of goods might be too tall of a task for most of the property industry but Nelson thinks that better metrics for inflation as it pertains to the property industry than CPIs exist. He suggests using the GDP deflator, which is what economists use to discount the growth of the countries’ total gross domestic products based on what the currency is worth. Unlike CPIs, which consist of a set, predetermined group of goods and services, the GDP deflator’s “basket” changes each year because it is based on the total of all goods that were produced domestically
As for how commercial real estate has fared recently, Nelson admitted that he expected a bigger shock from the pandemic. “I thought that with the economic shock of a global pandemic we would start to see cap rates would go [and property prices would go down] but that hasn’t happened,” he explained. “Even now, with all of the worry about inflation, we have not seen commercial real estate prices come down much.” Money is still flowing into commercial real estate and many investors are seeking shelter from the rising tide of inflation in real estate as it is thought by many to be a hedge against rising prices.
An aphorism used when times are good is: “A rising tide raises all ships.” The same can be said for times of inflation. The rise of the price of one good tends to bleed into others. Workers need more money to pay for a higher cost of living. Prices for products tend to go up as their possible substitutes get more expensive. So what better place to shelter your investment from inflation than one of the most universally consumed products: space? The market for many types of real estate has never been hotter, fueled no doubt by people looking for the inflationary hedge that owning property is known to be. But how much can a rising tide raise the marina that our economic boats are tied to?
To help me understand that question I talked to Nicole Funari, Vice President of research at Nareit, a trade association that represents both private and publicly traded real estate portfolios called REITs. She has been studying the pandemic’s impact on real estate stocks and that means trying to understand what the market thinks inflation will do to real property’s future value. She explained that the inflation that is being reported now is not the kind that will have a significant impact on a property portfolio. “For the most part, the real estate doesn’t have high labor costs, and many other costs like energy get passed onto tenants,” she said.
The pass-through of costs to tenants doesn’t just stop at things like energy, many leases have rent escalations that are tied to CPIs. The connection between inflation and lease prices might have a significant lag but eventually, they should catch up. All of these led to Funari’s telling me, in a calculated way typical of economists, “I don’t like to use the word hedge, but I will say that commercial real estate is a good inflation protection.”
Every type of real estate offers different protection against inflation, though. I reached out to Timothy Savage, Professor at NYU Schack Institute of Real Estate about some research he and his colleagues had done on the topic. By looking at historical returns of different property types through both high and low inflation periods Savage and his team were able to see which buildings were best able to keep up with the rise in overall consumer prices.
“If you look at total returns, income plus yield, retail was a very strong hedge against inflation,” he told me, explaining that, “the price of the products they sell can be adjusted quickly.” He also noted that multifamily and industrial properties are also good hedges inflation since their costs are also associated with the prices of goods. What didn’t seem like a good inflation hedge, however, was office. Office leases tend to be for longer terms and office tenants, unlike other renters, often look for a more economical substitute for their space when prices go up
Workers would want more for their work if things start costing more, but that was the 1970s when unions had power. We don’t have that today so there is no mechanism for wages to follow prices upwards.
Timothy Savage, Professor at NYU Schack Institute of Real Estate
One of the reasons that offices don’t have the same ability to keep up with inflation is due to the change in how office workers have been able to negotiate. “We used to think about inflation as a wage and price spiral,” Savage said. “Workers would want more for their work if things start costing more, but that was the 1970s when unions had power. We don’t have that today so there is no mechanism for wages to follow prices upwards.”
As for what metric he thinks is a better gauge of inflation for the property industry than CPIs, Savage told me that he watches the yield curve, which depicts the different rates of interest for different term lengths of debt. Right now that curve is relatively flat, representing a historically low spread between short and long-term debt. The reason, Savage explained, has to do with the world’s perception of how much of a long-term problem inflation will be, “If markets perceived inflation risk to be sustained we would see higher rates for long-term debt, which we don’t. That tells me that while many lenders are worried about lending in the near future, say three to five years, they are still very bullish on the global economy in the next twenty or thirty.”
Probably the most pertinent effect of inflation on real estate might be the governmental reaction to it. Since inflation is viewed as a tax on the public, central banks do whatever they can to counteract it. The thing is, there is really only one thing they can do and that is to raise interest rates. Higher interest rates can also slow down an overheating economy and help savers and lenders make up for their increased risks. But neither of these seems to be the case this time around.
Again, the inflation that we are feeling right now is not due to exchange rates for our currency or a red-hot economy. Our current inflation is due to the real prices of products and services going up. The Fed can, and will, raise interest rates but doing so will not help bring down the prices of moving goods through a clogged supply chain or help hire scarce workers. Plus, the Federal Reserve Chairman knows that when they raise rates, they need to do it in a way that doesn’t scare the market. Uncertainty is the boogeyman for speculators and so rate increases are always premeditated and transparent. Creating the roadmap for interest rates in such a public way is good for investor confidence but ties the government’s hands-on how far they can go.
Activist investors and economic pundit Bill Ackman lobbied for a “shock and awe” approach from the Federal Reserve to help improve its “perceived credibility as an inflation fighter in a series of tweets last month. He thinks that an unexpected move from the notoriously predictable organization would help ease fears that inflation might be getting away from our ability to tame it.
As much as a surprise announcement from the Federal Reserve on interest rates would make headlines, whether it would have the desired effect is unknown. “I don’t know if rate changes really affect things as much as we think,” said L.D. Salmanson, Co-founder of real estate data company Cherre. “Let’s say we raise interest rates like five percent, something ridiculous. Does it make people stop investing in government bonds? No, it might take a bit of demand away for the dollar but other bonds and investments are going to just adjust alongside.”
Salmanson helps real estate companies model their portfolios and a huge part of that equation is the cost of capital or the rate at which a company will be able to borrow in the future. Right now there is very little clarity on the short-term future of the lending market but that might not matter much either. Most properties that had the ability to refinance already did in this prolonged historically low-interest rate environment. Those loans will not come do for years and, if the still robust market for long-term debt is right, inflation might have subsided by then.
Bill Ackman was surely being self-serving with his high-profile tweets to the Federal Reserve Board but he had one point that did point to the larger repercussions of the inflation conversation. He said in one tweet that if enough action was not taken to combat inflation it would have “painful economic consequences for the most vulnerable” and this is likely true. When I asked Salmanson what other metrics we should be looking at to understand what inflation will mean for real estate he said, “I think a lot of people overlook the importance of the Gini coefficient.” The number, first developed by the statistician and sociologist Corrado Gini, is a statistical representation of the wealth disparity in a country. “Some of the current drivers of inflation might not affect those who are fortunate enough to own real estate,” Salmanson said, “but they can be devastating for the lowest earners and that can be really destabilizing for our society and therefore our economy.”
Inflation is inevitable, as economies grow so do prices. But it isn’t universal. As much as we would like to boil the concepts behind the value of our money into one easily digestible number, the result is anything but precise. The lasting effects of the pandemic have the entire world worried about inflation, which has led many to re-examine how real estate performs during inflationary periods. But as much as we might be able to learn from past inflation, this current inflation is, like the pandemic that preceded it, unprecedented. There are signs that real estate might be largely spared from the negative effects of the inflation we are feeling now but that doesn’t mean that we are out of the woods yet. If inflation starts cutting into our savings and curbing our spending it could add another roadblock for an already shaky pandemic recovery. Before that happens we need to do a better job of understanding the impact of inflation and that, of course, starts with a better definition for what exactly the word means.