Inflation Hysteria Without Merit?
Board: Real Estate Investment Trusts: REITs
Prospects for economies and financial markets are always uncertain, but it seems that no two economists or market strategists can agree on anything these days. Some of the many shrill voices emanating from our Tower of Babel concern inflation. Certainly food, oil and other necessary commodities have been rising rapidly of late – but is this a portent of a near-term rapidly accelerating pace of inflation, or just a temporary blip that will fade as quickly as Charlie Sheen’s popularity? Getting the inflation answer right could have very significant consequences for investment portfolios.
Let’s consider the views of just two well-known personages. Chairman Ben has been claiming that the current spike in prices is temporary and limited. On March 1 he told Congress not to worry, saying, "The most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation." On the other hand, Bill Gross and his Pimco organization seem to be more concerned. According to Bloomberg, Pimco’s “Total Return fund [recently] had a negative 3% of its assets in government and related debt,” suggesting that Mr. Gross is a bit spooked about future rates of inflation. Indeed, Mr. Gross recently told CNBC that Mr. Bernanke is being naïve in thinking that inflation will revert back to the mean. Who is right?
Being no economist, I certainly don’t know (assuming being one would help me with the right answer – a very dubious assumption). However, it seems to me that an uncomfortably high and sustained rate of inflation, i.e., anything over 2-3%, would depend upon at least three key factors: (a) persistently rising employment costs, (b) the ability of purveyors of goods and services to pass along cost increases to customers, and (c) a significant and persistent devaluation of the US dollar relative to the currencies of our trading partners. And, I would argue, the inflationists will have a difficult time convincing me that any of those factors are present these days. Consider:
Employment is improving, but only slowly and grudgingly, and meaningful wage and benefit increases in most sectors of the US economy are almost as scarce as long-term investors. Pricing power for most businesses is conspicuous by its absence – just ask the producers of steel or household goods how easy it is to pass along cost increases. Few clothing retailers are confident of being able to raise prices by 4-5% despite rapidly rising materials costs. And, while the US dollar has been weak recently, short-term currency fluctuations cannot easily extrapolated into longer-term trends; Europe, Asia and Latin America each have their own problems that are likely to put a floor under the US dollar – particularly if Congress decides to get real about reining in our massive budget deficits.
There are also a few other reasons why I don’t think inflation will gallop ahead here in the US. There is still excess manufacturing (and even service) capacity everywhere, and inflation is often the effect of the opposite situation; even lawyers and dentists are having a hard time finding jobs these days. Also, rising food, oil and other commodities prices are equivalent to stealth tax increases that will sap consumer purchasing power and make it even tougher for sellers to wield pricing power. Note, too, that investors and traders in many commodities are refusing to dance the contango, e.g., yesterday July 2011 Brent Crude was quoted at $120.53, but July 2012 Brent Crude was quoted at $115.73. And the Wall Street Journal, on Tuesday, noted that money growth, as evidenced by “M2,” often a key to inflation, has been quite subdued despite improvements in the US economy.
So, while I – like everyone else – am watching the inflation picture carefully, I am skeptical that the current inflation buzz will be more than a typical concern du jour. But, to quote Bill O’Reilly, of course I could be wrong. Let’s proceed then, to briefly consider how our REIT stocks might react to a sustained period of above-normal inflation.
There is a surprising dearth of studies on how inflation affects the owners of commercial real estate, and I believe that it is gross oversimplification to claim that inflation always benefits these owners. One academic paper that caught my eye recently was penned by David J. Hartzell, Professor of Real Estate at the University of North Carolina, along with R. Brian Webb. They concluded that commercial real estate owners’ returns tend to exhibit stronger relationships with inflation and its components during periods of low vacancy rates. If this historical correlation persists into the future, a reasonable expectation would be that inflation can benefit real estate owners – but only if property markets are relatively firm.
This is quite logical. If inflation accompanies a healthy and growing US economy, several benefits may accrue to the owners of commercial buildings. They will have pricing power with their existing and prospective tenants, due to strong occupancy rates, which improve property cash flows. By making new projects more expensive due to rising land prices and building costs, inflation will deter new competing product – or, at the least, give owners some pricing protection for the rents they seek to charge to users of their existing space. And higher land values would likely boost the prices of commercial real estate generally, and increase replacement cost. Retail real estate owners, in particular, would benefit by higher tenant sales in an inflationary environment.
But there are countervailing factors. Once it becomes evident – if it does – that significant inflation has arrived, interest rates will rise. This could slow the US economy and dump cold water on our space markets, making it more difficult for owners to exert rental rate pricing power. Rising interest rates and the threat of an economic slowdown will tend to push up cap rates, and weaken commercial real estate values. Consumers will reduce spending, causing retailers to push back hard against increases in retail rental rates. Even a recession could result if interest rates rise too much and too quickly.
The bottom line here is that economies and markets are extremely complicated; some have even applied Chaos Theory to the functioning of financial markets, and there is merit in some of their arguments. The world is just too complex and interdependent for anyone to be able to predict, with any accuracy, where inflation will go and how it will affect investors in various asset classes. The irony is that getting the Big Picture right will have a much greater impact upon investment returns than figuring out which stock or property to buy or sell.
So we are left with making our humble forecasts and taking the leap of faith that they are somewhat accurate – or at least more accurate than the next guy’s. Here are mine: (1) commodity inflation today is worrisome but transitory; (2) the “new normal” economy will be with us for another couple of years as debt continues to be liquidated, while excess capacity, high unemployment, and budget cutting and other headwinds keep economic growth below normal and limit pricing power; (3) our space markets will continue to recover, but slowly, and NOI growth will remain modest in most sectors for at least the next two years; and (4) under these circumstances, quality commercial properties – but not junk – will trade at low cap rates and provide historically modest (albeit acceptable) internal rates of return. That’s my story and I’m stickin’ to it.