Tran-si-to-ry | adj. 1 of brief duration 2 tending to pass away : not persistent (Merriam-Webster)
The United States has experienced five months of inflation exceeding 5%, with the October figure clocking in at 6.2% – the largest rate since 1990. As such, many are seriously questioning the transitory nature of inflation. Consider that the term “transitory” has no theoretical limit; whether inflation above 5% continues for five, seven, or ten months, there will always be room to label such as transitory. At some point, semantics become irrelevant, and people begin losing trust in the system.
Inflation is no longer confined to categories related to the pandemic. Not only are food and energy prices surging, but so too are commodities outside of these sectors. Prices for the latter have increased by an annual 12% in October. Now Federal Reserve Chairman Jerome Powell says he expects current inflationary pressures to persist into 2022. At what point is the term “transitory” inappropriate?
The inflation threat is far from a topic of interest only to academics, investors, and C-suite executives. Business owners are faced with ballooning labor costs, while employees – the typical beneficiaries of rising labor costs – are becoming worse off in real terms. Real wages are declining, meaning employees can buy less stuff, their pay raises notwithstanding. In October, monthly inflation ran at 0.9%, and wages grew by 0.4%, implying a 0.5% decline in real wages.
Since the onset of the pandemic, the Fed has been engaged in aggressive quantitative easing (QE) efforts, acting as a support mechanism for the economy, namely by purchasing $120 billion of Treasuries and mortgage-backed securities (MBS) each month. Now the Fed has committed to slowing asset purchases by reducing monthly Treasury and MBS purchases by $10 billion and $5 billion, respectively. It’s important to note that QE is not being halted right now, but rather that the rate of QE is being reduced with the intention of ending the purchases by next June. Some market participants are calling for the Fed to accelerate tapering to bring inflation under control. Others are calling for immediate rate hikes, highlighting the less efficacious nature of balance-sheet tapering over rate hikes.
The Fed’s decision to begin tapering is far from risk free. In 2013, then Fed Chairman Ben Bernanke sparked a bond sell-off and surging yields by announcing the bank’s intention to taper QE. With the economy now in flux, such a scenario remains a concern to the market. Accelerating tapering, or not accelerating enough, may have marketwide implications spanning the likes of inflation, interest rates, and output.
What does this all mean for real estate?
If inflation is expected to rise, bond yields typically react by rising to compensate for the eroding effects of rising prices. As shown in Quantifying Market Relationships with National Cap Rates, rising bond yields certainly do not necessitate rising apartment cap rates and declining property values. Counterintuitively, bond yields and cap rates can move in opposite directions depending on what window of time we look at.
Even if inflation persists at current rates, potentially reaching or breaking 7%, apartments are a strong addition to any portfolio. As shown in A Better Way to Assess Inflation and Risk in Real Estate and covered in Inflation Fears are Driving More Investors Towards Commercial Real Estate, apartments tend to weather inflation very well – returns tend to rise with rising inflation. The same cannot be said for the overall stock market – inflation tends to hurt stock returns.
If the Fed overaccelerates tapering and allows yields to spike too rapidly, stocks could fall, as earnings may not keep pace with a rising discount rate. Having exposure to private apartments could be beneficial in this scenario.
We at Berkadia will continue monitoring inflation and encourage your reaching out to see how we can help you navigate the complexities of commercial real estate.
-Noah Stone, Economic Analyst