Reports that consumer prices spiked 1.1 percent in June raise the issue of inflation, which has in the past been advantageous to real estate investors. In the current state of the market, it’s not clear if rising inflation will end up being a boon or a burden on top of the credit crisis.
During the inflationary periods of the 1970s and 1980s, many investors who held real estate made out reasonably well, reinforcing the idea that real estate is a good investment for bad times.
“A lot of people buy real estate during inflationary times with the idea that it would be a hedge against inflation,” said Robert Stella, an executive vice president and principal at Cresa Partners, a commercial real estate brokerage. “Say it cost you $1,000 to build a building. If inflation goes up 10 percent, your building’s probably going to be worth at least 10 percent more, or $1,100, so that’s good.”
Inflation is often thought of as a beneficial phenomenon for real estate investors, agreed Jim Frederick, an executive managing director and principal at Colliers ABR, a commercial real estate services company.
“Hard assets are always more attractive in inflationary times,” Frederick said.
Since inflation, in a sense, can add equity to a building, it can effectively take a bite out of the building’s debt, Stuart Saft, a real estate partner at law firm Dewey & LeBoeuf, said.
“Credit is more significant in real estate than any other aspect of the economy, because real estate is basically an illiquid investment,” Saft said. “Having a period of inflation, if you’re a real estate owner or lender, solves the credit problem, because suddenly, the value of the asset can be in excess of the amount of debt that’s on the asset.”
However, real estate investors in today’s market face other pressures that make it less advantageous to own real estate now. First of all, the absence of cheap and easy financing makes it difficult to sell a building and reap any immediate benefits from inflation, Stella said.
“If people aren’t buying your building because they can’t finance it, the value is only a paper value,” he said. “That’s a new twist that could create some issues for an investor trying to hedge, because if you want to sell it, there may not be many buyers — at least until this credit crisis plays out.”
Paul Fried, a principal at AFC Realty Capital, a national boutique investment bank, said real estate might be a hedge in inflationary environments — as long as it’s not the sector that went through the inflationary period.
“Normally, you would think it would be good to hold real estate in an inflationary period, but you’re assuming real estate is not the asset that’s in the inflationary cycle,” he said. “Right now, real estate values are at historical highs as a result of going through an inflationary cycle caused by cheap monetary policy.”
The Federal Reserve’s reaction to inflation may also determine whether or not real estate investors thrive, or have to struggle to survive. The Fed could decide to increase interest rates.
“What matters to real estate is the real interest rate, which is the nominal interest rate minus inflation,” said Mark Zandi, the chief economist and co-founder of Moody’s Economy.com.
“If you have an acceleration of inflation and interest rates don’t rise, i.e. if the Federal Reserve doesn’t tighten policy, then generally, it’s good for real estate,” he said. “If conversely, though, inflation rises and the Federal Reserve tightens policy, and real rates increase, that’s bad for real estate.”
Zandi said he believes the latter is more likely, with the federal government sacrificing the economy to achieve the goal of stable inflation.
“In the 1970s and early 1980s, inflation increased, but the Federal Reserve did not raise interest rates, so real rates went negative, which was good for real estate,” he said. “That won’t happen this go-around.”
Saft agreed with Zandi, asserting that officials in the Federal Reserve, which had been gradually cutting interest rates to aid the struggling housing market, will worry that investors will shift their capital from U.S. securities markets to other markets where they can get a higher return. The federal government will raise interest rates to attempt to make the U.S. securities market more competitive.
“That’s where the real pressure on the Federal Reserve to raise interest rates is going to come from,” he said, adding that it will have a devastating effect on the housing market. “Raising interest rates will make the dollar more competitive as an investment, but on the other hand, it’s going to trigger more defaults here in the U.S.,” he said.
Fried said that if Federal Reserve officials raise interest rates, it will be a “double whammy” to real estate values.
“You know they’ve got to be struggling with this, because the instinct is to raise rates, because that is better for monetary policy,” he said. “If they do raise rates, you’re really going to get squeezed in terms of tightened underwriting standards along with the increased cost of capital.
“So does it feel like real estate is a hedge?” Fried continued. “The answer is ‘no.’ Don’t argue with your gut on this one.”
Still, Fried said, while real estate as a sector may be hurt by increased interest rates, individual assets with either solid fundamentals or strong cash-flow that are being held in the longer term should be “reasonable places to be.”
But real estate owners with floating interest rates — for instance those who took out short-term loans 18 months to three years ago to purchase transitional buildings with a vision of turning them around — may end up losing their properties if the Federal Reserve raises interest rates, Fried said.
Frederick said he thinks the Federal Reserve will be sensitive to the credit problems plaguing the real estate market and forego raising interest rates.
“I don’t think the Fed will be able to raise rates any time soon because of the continuing banking turmoil and most recently the issues with Fannie and Freddie,” he said.
Frederick Peters, the president of Warburg Realty Partnership, a residential brokerage firm, said the looming problem for the mortgage market is not simply more conservative underwriting standards, but a shortage of capital altogether. For that reason, the Federal Reserve won’t raise interest rates.
“On the one hand, you have an economy that’s not zippy, and which to some degree is being stifled by the general lack of credit,” he said. “On the other hand, you have this threat of inflation.
“Ordinarily, you’d try to pump energy into the first problem by lowering rates,” Peters said. “And ordinarily, you’d try to manage the second problem by raising them. So my guess is, at least for the time being, [Federal Reserve Chairman Ben] Bernanke’s not going to do anything.”
In the meantime, price inflation caused by more expensive petrol-based construction materials, along with increased global competition, will make new real estate development less feasible, he said.
And as the rate of inflation increases, the value of payments on longer-term debt decays. Yet many New York City residents are protected simply because the large number of co-ops in the city means many people are no more than 75 percent financed. Still, depending on what happens with real wages, homeowners will most likely pay a larger chunk of their income toward common charges.
In the commercial market, there’s an air of uncertainty because costs are going up due to inflation for both tenants and landlords, said Abraham Hidary, the president of Hidrock Realty, which is a commercial real estate services firm that also serves as a landlord. Landlords often tend to shift excess costs to tenants.
“Tenants are being squeezed, so they are avoiding signing long-term commitments right now; they’re waiting until the last possible second to sign a lease extension or to move,” Hidary said. “And if they do have to sign a lease, they’re keeping it as short as possible — a five- or seven-year lease versus a 10-year lease.
“And if they do have to move, they’d rather be in a quality building a little bit off location to keep their rent down.”