Earlier this year, the possibility of inflation was being discussed. The Federal Reserve (the Fed) and President Joe Biden opined that inflation then was transitory. Now as the first quarter ends, we have seen significant increases in the cost of goods and services. Prices increased 6.1% in January and gasoline prices are approaching $6 per gallon. I am not a school educated economist, but I think we can safely say that we are in an inflationary cycle.
As consumers and businesspeople, the questions we might have on inflation are:
- How long will or could we have inflation?
- What might we expect for the effects of future inflation as relates to commercial real estate?
- What mistakes were made in the past during similar conditions to avoid today?
Let’s start with a look back into the late 1970s and early 1980s. In the late 1970s, Jimmy Carter was president. In 1973/1974 OPEC (Organization of Petroleum Exporters) placed an embargo on exports of crude oil to the United States. We hadn’t achieved energy independence that we enjoyed under presidents Barack Obama and Donald Trump. As you can guess, the cost of gas at the pump exploded. Also, we had been spending heavily on the war in Vietnam, which came to an official end/defeat with the fall of Saigon on April 30, 1975. Also, according to some economists, another cause was higher and growing wages. Labor unions were much stronger then and were able to push wages up.
Today, we have a super-heated economy with many consumers sitting on unspent federal stimulus money and pent-up demand following the COVID-19 lockdowns. This is combined with worldwide problems with the supply chain. The potential Build Back Better plan will push $1.3 trillion dollars into the economy. Just that $1.3 trillion dollars could add to inflation. In addition to that increase in the money supply, we had rising crude oil prices before the war in Ukraine and the disruption to the world’s supply. And talk about bad timing; our American politicians had earlier declared war on fossil fuels, which discouraged domestic exploration and investment in new infrastructure. But the United States wasn’t alone in ill-advised policy; Germany was actively shutting down its nuclear power reactors without replacing that energy source. It appears they were going to rely on cheap Russian natural gas. Whoops.
Thus, we are approaching a perfect storm of many negative factors colliding at once. Let’s look at historical data — I know a lot of Americans hate studying history. They prefer to re-learn painful lessons.
Past inflation rates:
- 1976 was 5.74%
- 1978 was 7.63%
- 1979 was 11.25%
- 1980 was 13.55%
- 1981 was 10.33%
- 1982 was 6.13%
The “Economist” has a phrase that explains what happens. It says inflation “is baked into the economy.” Suppliers raise their prices because they anticipate higher costs for their materials. Labor and workers push for higher wages because everything they buy costs more. Commodities like gasoline and food cost more and more. Once inflation is “baked in,” it’s hard to stop or slow down.
From our economic history one could draw the conclusion that only a dramatic event or action might break an inflationary cycle. Raising the prime rate interest rate is a go-to tool for the Fed.
Here are prime interest rates for those years:
- 1976 was 6.25%
- 1978 was 8%
- 1979 was 11.75%
- 1980 was 16.75%
- In November 1980 it was 21.5%
- 1981 was 18%
I remember President Ronald Reagan saying, “I am going to wring inflation out of the system.” I guess he meant with higher prime rate. Those astronomically high prime rates had big effects. The economy was thrown into a recession. Commercial real estate development hit a brick wall. New construction projects were not economically feasible with construction loans based on prime rate plus two points. Home loan interest rates were extremely high. My wife and I bought a single-family home in 1982 and got a 16.5% loan and were thrilled to get it.
In those years of high inflation, office and industrial rents and property values were going up. Many tenants and occupiers of space wanted to own to put a lid on their rising rents and as a hedge against inflation. With this buyer interest, developers responded by building office and industrial parks of multiple small buildings that were available for purchase. So, I think we will see the demand for ownership again.
Why is real estate considered a hedge against inflation? It is based on the buying power of the dollar and how inflation reduces that buying power. In effect, the dollars in the future become cheaper or worth less. When you finance the purchase of real estate with a set interest rate, the dollars you borrowed are more valuable than the dollars you are paying back the loan with. And inflation tends to drive up the prices for commercial real estate. So, there are two factors hedging against inflation.
What mistakes were made during that last period of hyperinflation? Some tenant occupiers thought that all real estate was a great investment when they could occupy the building and run their business in it. They forgot that for real estate, it’s “location, location, location.” And in the rush to own they bought in areas that were not well located. Another mistake was buying during the feeding frenzy and overpaying in the belief that the value of the real estate would always go up. The trouble was the super high prime rate threw the economy into a recession. Property values do not go up in recessions.
Another big mistake made was designing the building to specifically meet “their needs.” Why not? It is your building, right? Nobody, especially the developers who sold them the buildings, told them that to get the highest possible price when you decide to sell, the building needs to have the widest possible appeal or utility. An office or industrial building built as “spec” is a different animal than one built custom for one user/owner. A lot of people got stuck with buildings they couldn’t sell for the price they had expected or hoped for.
If you decide to try to invest in our local commercial property sector, do your homework; consider those past mistakes and don’t repeat them. It’s always a smart move to have a very experienced commercial real estate broker acting as your advisor to supply up-to-date market information: available options, new projected construction and what properties are trading for.
— Bill Beck is the founding principal of Tenant Realty Advisors.