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Inflation Seen As Low Risk for Commercial Real Estate Investors

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 concern 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.

*Article courtesy of CoStar

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Wolf Commercial Real Estate, a full-service CORFAC International brokerage, and advisory firm, is a premier New Jersey and Philadelphia commercial real estate brokerage firm that provides a full range of New Jersey and Philadelphia commercial real estate listings and services, property management services, and marketing commercial offices, medical properties, industrial properties, land properties, retail buildings and other New Jersey and Philadelphia commercial properties for buyers, tenants, investors, and sellers.

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