Inflation Looms as the Next Sword To Swallow

Amidst softening commercial real estate space demand, flattening rents and tight credit, a new concern is coming to the forefront: the double-edged sword of inflation. Double-edged because inflation can cut across property markets in ways that are both favorable and unfavorable.

Increases in commodity prices such as oil and gas and the decline in value of the U.S. dollar against other currencies are fueling inflationary pressures across the U.S. The year-over-year wholesale and consumer price increase, including food and energy, is running close to 5%, according to June government numbers. The country hasn't seen those rates in nearly 20 years. Excluding food and energy, the rate is about half that (2.4%), but even that is "above the level consistent with price stability," according the Federal Reserve Bank in Philadelphia.

While there are arguments over just how inflation is measured and what the inflation rate is, there is agreement that either measure is higher than it should be -- and the outlook is deteriorating.

Rising inflation is an increasing concern among economists because it could undercut recent stimulus efforts the federal government has taken to pull the economy back from the edge of recession. An increase in inflation expectations could lead to higher interest rates, which could negatively affect the value of property portfolios, increase borrowing costs and potentially lower earnings.

That interest rates have nowhere to go but up seems pretty clear. After cutting the federal fund rate seven times from 5.25% last September, the federal government is now lending banks money at 2% interest. The consequence is that the interest rate on federal funds is now negative - between minus 0.6% and minus 2.5% depending on which measure of inflation is used.

Keeping interest rates at that level for too long could only intensify the inflationary pressures. If the June inflation numbers continue through the summer, the Federal Reserve will have to increase rates sooner rather than later.

Hedging Inflation

One of the big concerns about inflation is the fact the industry has not had to deal with it for so long, said Kenneth B. Blye, principal of CresaPartners in Newport Beach, CA.

"While the general wisdom is that real estate is as an inflation hedge, it is generally a hedge only to the extent it is anticipated," Blye said. "Decisions made up until recently - and apparently those being made now - have not and do not take rising inflation - not just inflation - into account. As inflation sets in, leases with 3% annual bumps are going to seem pretty anemic if annual inflation starts running 5%, 8% or higher."

"Overall, the onset of high inflation, particularly unanticipated inflation, will create large penalties and rewards [the two-edged sword]," Blye added. "While some who planned wisely or successfully hedged for inflation will benefit, the costs and benefits will vary widely and almost randomly. Dumb luck will likely play a much larger part in creating winners than wise planning."

"Decisionmakers and investors don't know how to react to rising inflation," he added. "The vast majority of these [investors] cut their teeth well after the last inflation run-up of the mid- to late-1970s and have never seen a period of sustained rising inflation."

On top of that, the easy credit market conditions of the 21st century until recently have spoiled many, said Brian S. Brennan, director, real estate acquisitions for Allianz of America in Westport, CT.

"Post 9/11, America has enjoyed some of the lowest costs of capital in our modern history," Brennan said. "Particularly cheap debt has fueled an economic velocity that ultimately overwhelmed the financial markets when the consumer took their foot off the gas pedal. Inflation now serves as a punitive tax by diluting real wage growth, shrinking real return on investments and robbing purchasing power."

But even in making investment decisions, the two edges of inflation are evident, because just as inflation can rob purchasing power, it can also benefit buyers.

"We have a bunch of buyers waiting for the market to go down not realizing that inflation has taken the market down already by at least 10%," said Sagiv Rosano, managing partner of Rosano Partners in Los Angeles. "The smart investors that are buying now are going to find out that they bought great deals in tomorrow's dollar."

Leasing is Key

The key, Rosano and others said, is how property leases are structured. Provisions in the majority of leases protect owners from the impact of inflation. These provisions include rent steps, reimbursement billings for operating expense pass-through charges, real estate tax and insurance reimbursements on a per square foot allowance.

However, due to the anticipated long-term nature of the leases, among other factors, the leases may not re-set frequently enough or high enough to cover inflation. Many leases just bump up at a set percentage no matter what the consumer price rate hits.

Rosano explained, "Since many of the Walgreens and Rite Aids out there are not on a [consumer price index]-adjusted leases, it is scary what will happen if we had 10% to 12% inflation. We have clients that bought these Walgreen 'retirement properties' who are going to be OK making the mortgage payments, but will have a lot less real money in their pockets."

"I have seen increases as low as three quarters of a percent per year. Most are in the 2% range," said Keith W. Barker, president of K.W. Barker Inc. in suburban Maryland outside of Washington, DC. "Rarely are the adjustments annual, especially in the early years of the term."

Already the industry is starting to make the shift, according to Bill Martien of Sonetta Properties in Baltimore, who gives this example.

"My dad manages a small 20,000-square-foot office/warehouse fully occupied by a single tenant," Martien said. "Recently, the tenant came to the end of a five-year lease that bumped 2% annually. When they wanted to renew [there were no options] my dad insisted on the renewal rent being tied to CPI."

In the near term, full-service leases will be devalued as energy costs are absorbed by the landlord and triple net (NNN) leases will be valued upwards for the same reason, said Alex Kent, managing director of Symphonic Investments in Burlingame, CA.

However, resetting leases escalations and passing on rising expenses won't be easy in today's market, said George A. Venner Jr., president of First Texan Real Estate Services in Mesquite, TX.

"If you increase the lease, many folks will just fold and go out of business in this market, and the landlord may wish they hadn't have gone out of business a year later [when the space is still empty]," Venner said. "Operating expenses and materials will go up because of fuel and inflation. It's going to be hard for the landlord to raise rents on tenants in any sector because just about every small business or retail type business is tapped out it seems."

Murphy's Law

Overall the commercial real estate industry is facing a barrage of problems, and Kevin Murphy, principal of The BridgeTown Group in Jacksonville, FL, listed all of them: lower dollar value, negative real interest rates, residential construction overhang, tight credit markets, higher transportation costs and resulting higher food and commodity prices, steady population growth, monetary and fiscal problems (if not mismanagement), a Presidential election and a burdensome national as well as personal debt level.

But Murphy adds: "Now you would think, after this litany of issues, I might be a little negative about things, but I actually am quite positive over the long-term. I think we are experiencing a periodic 'cleaning-out.' As long as the government doesn't over-react, the economy will find its bottom and grow from there. In all this activity or 'right-sizing,' a lot of wealth will be created, which, at the end of the day, will more than offset the amount of wealth destruction we have seen to date."

"For commercial real estate holders, the impact differs by property type where countervailing developments are either offsetting or exacerbating results," Murphy said.

Here is Murphy's take on how different property types are faring in current market conditions:

• Retail. Higher food and gas prices are stripping out a high degree of discretionary income impacting sales. Energy costs are driving more sales to the internet, which is lowering foot traffic. Storefront mortgage operations have disappeared and the result is higher retail vacancy. Coupled with higher operating costs, retail net operating incomes (NOI) are falling and with them values.



• Office. Generally slower economic growth is having it' typical impact on office occupancy. Coupled with higher operating costs, office NOIs are stagnant at best. Credit market issues have made investment sales of offices difficult to secure even though the real interest rate remains negative.



• Multifamily. Continued Federal Housing Administration financing has buoyed up new construction in this asset subclass. Rising unemployment and deteriorating tenant credit along with increasing property operating costs have yet to seriously impact valuations.



• Industrial. The weak dollar is driving export growth and transportation costs are causing a rethinking of distribution networks keeping the industrial property market reasonably healthy. Less competition from residential land buyers has made land cheaper and a greater supply of construction trades has made not only industrial construction a bit cheaper but is impacting all new construction positively.



• Mixed-Use. One aspect of new urbanism - light rail, when coupled with the higher gas prices - is prompting more multi-use construction along the rail corridors.