Normally inflation works in favor of commercial real estate investors, driving up demand for hard assets as a hedge against a weakening currency. Because inflation typically occurs amid an expanding economy, the escalating corporate revenues and demand for space that accompany price spirals usually fuel rent growth, which in turn boosts real estate cash flow and property values.
That sort of boost to net income would validate today's lofty asking prices on commercial properties and help bridge the gap between buyers and sellers that has brought transaction volume to a trickle. Case in point: May's $2.6 billion in office property sales marked the lowest monthly total in five years, down 87% from a year earlier, reports Real Capital Analytics.
Unfortunately for investors, today's inflation reflects global supply problems rather than an expanding economy at home, so it lacks most of the characteristics that have benefited commercial real estate in previous inflationary periods. While crude oil prices hit an all-time high of $142.99 per barrel on June 27, U.S. wages are basically flat. Adjusted for inflation, personal income in the first quarter was up just 16 basis points from a year earlier, according to Reis.
The U.S. economy expanded at an annualized rate of just 1% in the first quarter and the nation shed 232,000 jobs — hardly ideal drivers for real estate absorption and rent growth. In the second half of 2008, inflationary pressures are more likely to hurt than help property values because inflation leads to interest rate hikes, increasing the cost of capital.
Think of it as Round II in the investment slowdown sparked by the credit crunch, when higher borrowing costs left asset prices beyond the reach of many leveraged buyers.
“The risks are to the downside, that inflationary pressures would negatively impact investment activity,” explains Sam Chandan, chief economist at Reis. “As those baseline interest rates go up, it's going to drive up the cost of credit.”
At best, inflation will prolong market uncertainty, so investors waiting for better days may have a long wait. Active buyers say investors willing to shop today's offerings hold distinct advantages compared with this time last year. But first, investors need to consider inflation's implications for real estate.
At $1.37 per pound, bread cost 15% more in May than it did a year ago. The price of iron and steel climbed 32.5% during the same period, according to the Bureau of Labor Statistics. Mounting inflation around the globe threatens to knock the U.S. economy flat or into a full-blown recession, which would halt absorption and rent growth while quashing hopes for a timely end to the credit crunch.
That puts the Fed in a quandary as it tries to help banks regain their footing by keeping interest rates low, says Mark Dotzour, chief economist for the Real Estate Center at Texas A&M University. “Every day that they keep rates low, the inflation genie gets further out of the bottle,” Dotzour says. “I'm afraid global inflation will force the Fed to start raising rates before they intended, before the banks have healed enough to withstand higher interest rates.”
Hikes in the overnight Fed funds rate increase banks' costs, which could reverse liquidity gains lenders have made while dealing with massive write-downs on bad loans. The Federal Reserve sounded the inflation alarm June 25 when it held the Fed funds rate at 2%, ending nine months of rate cuts intended to stimulate a flagging economy. The Fed is concerned that a combination of rising food and energy prices could weigh heavily on the economy for several quarters.
The core Consumer Price Index, which excludes food and energy costs, was 2.3% higher at the end of May than it was a year earlier, according to the Bureau of Labor Statistics. That's already outside the Fed's unofficial comfort zone of between 1% and 2%, and most economists expect core inflation to remain near 2.5% through the end of 2008 (see chart above).
A more immediate problem for the economy is headline inflation, which includes skyrocketing food and energy costs. The overall Consumer Price Index was up 4.2% in May from a year earlier chiefly due to a 17.4% spike in energy costs. Food prices rose 5.1%.
Those prices stem from food shortages around the globe and a tight supply of oil, and from speculation that oil orders will outpace production. Demand from developing countries also contributed to a steady run-up in the price of steel and other commodities while the weak dollar has driven up the cost of imports to the United States.
Effects on real estate
Headline inflation will likely remain high throughout 2008 and pose challenges for commercial real estate, says Jamie Woodwell, vice president of commercial/multifamily research at the Mortgage Bankers Association. “Increased fuel costs can have a significant impact,” he says. In May, the average price of oil used to heat buildings was $4.19 per gallon, up 63% from last year.
Consumers are already struggling under a negative wealth effect brought on by weak wage growth and high consumer debt levels, says Ben Breslau, research director for the Americas at Jones Lang LaSalle. Total household net worth declined 3% to $56 trillion in the first quarter from the fourth quarter, according to the Federal Reserve. Squeezed household budgets will reduce spending, weakening demand for retail space as well as office and industrial buildings catering to companies that sell goods and services.
Apartment landlords are especially vulnerable to fuel and energy price spikes, says Alan Fishman, chairman of New York-based financial services firm Meridian Capital Group.
In markets such as New York — where rents are regulated — landlords have a hard time increasing rent to cover high energy costs. Even for a fully occupied property, the resulting squeeze to cash flow can present problems in refinancing or for would-be buyers seeking an acquisition loan.
Most economists expect the price of oil to retreat by the end of 2008 to around $85 per barrel.
If $4-per-gallon gasoline lingers, however, tenants will weigh their employees' commute costs in their selection of leased space, according to Maria Sicola, executive managing director of research at Cushman & Wakefield. “People's ability to pay their mortgage will have a direct impact on where they will work,” she says.
The University of Michigan's Year-Ahead Inflation Survey found that consumers expect inflation to reach an annual rate of 5.2% next year, its highest level since 1982. If that happens, commercial real estate may yet enjoy a surge of transaction volume as buyers seek investments that retain purchasing power. “When you get into an inflationary environment, there's only about three places to hide,” says Dotzour of Texas A&M. “You can either buy an Andy Warhol painting, put it in gold, or buy real estate.”
The ongoing credit crunch may keep commercial real estate out of reach for most investors, however, according to Robert Bach, chief economist at Grubb & Ellis. “I would look at the debt markets as a restraint against real estate's ability to fill those shoes in this cycle,” he says.
Even for equity investors or those with willing lenders in tow, acquiring commercial real estate is a tall order in 2008. The re-pricing of risk has buyers and sellers in disagreement and there isn't sufficient deal volume to establish firm pricing. Investors who bought real estate at the peak of the boom can't recoup their purchase price in a sale this year, so most are choosing to wait for prices to rise, says Mike Meisenbach, a principal who covers the Orange County, Calif. office market at brokerage Lee & Associates. “Maybe in five years they'll be able to get out of it,” he says.
Adapting to market conditions
A handful of investors are buying commercial real estate while most of their competitors wait on the sidelines for prices to stabilize. Houston-based Hines Interests has invested $1.09 billion in five office acquisitions this year and is still looking for deals.
For owners without a pressing need to dispose of an asset, it's probably not a good time to sell, says Charlie Baughn, CEO of financial markets for Hines. Baughn believes prices on fully leased, well-located office properties have dropped 10% to 15% from last year's peak, but so far only a few owners are ready to sell at a discount.
Persistence has enabled Hines to find willing sellers, however. And unlike early 2007 when investors had to make a non-refundable deposit and investigate a property quickly before entering a bid, today's market allows time for thorough due diligence before committing to the deal.
“If you can find assets you like at a reasonable price, you're better off going ahead and seeing if you can make a deal today,” Baughn says. “If you wait for the price to come down, particularly on high-quality assets, I'm not sure they're going to.”
Investment banker John Levy, president of John B. Levy & Co., encourages investors to capitalize on today's relatively low interest rates and stop waiting for wide mortgage spreads to narrow. “We would not encourage you to wait,” Levy says. “Treasuries increase faster than spreads decline, and as a result as a borrower or an owner you actually pay higher rates.”
Grubb & Ellis Realty Advisors invested $451.2 million in 24 acquisitions across property types, including 13 office buys, in the first four months of 2008, according to Real Capital Analytics. The Santa Ana, Calif.-based investment subsidiary of Grubb & Ellis Co. has increased the number of potential deals under review by 70% over last year's pipeline, says Jeff Hanson, president and chief investment officer of Grubb & Ellis Realty Advisors. Even so, the company is buying properties at a slower pace than it did in 2007, when it purchased more than $2.1 billion in assets in more than 70 transactions.
This summer's active buyers say they can afford to be selective and focus only on the best deals. “We're not wasting time with unrealistic sellers,” Hanson says. “We're focusing on the real sellers that have a reason to sell.”
Selectivity is a must in the troubled retail sector, which registered a national vacancy rate of 11.5% in the first quarter and is expected to reach 12.5% by the end of the year, according to Property & Portfolio Research. “It's a nervous time in retail,” says Chris Robertson, chief acquisitions officer at Cole Capital Advisors Inc., a shopping center owner based in Phoenix, Ariz. “There's going to be a lot of store closures this year and I suspect there will be more store closures next year.”
Cole Capital plans to complete $1.7 billion in acquisitions this year and has already invested $318 million to add 45 properties to its portfolio since Jan. 1. The company is confining its acquisitions to core locations in primary and secondary markets, Robertson says. “We focus on assets where even in a tough economic environment those retailers are going to succeed, or they're not going to want to abandon the trade area.”
Like Grubb & Ellis, Cole Capital had to step up the number of deals it reviews in order to find a sufficient number of acquisitions and has doubled its staff in the past 18 months. “If you can touch enough deals, you can find the handful where the seller is willing to be fair and price the deal to reflect current market conditions,” Robertson says.
Catalyst for opportunity
Commercial real estate investors face a rough road in the second half of 2008. Flat economic growth constrained by burdensome energy prices will do little to drive absorption, and if inflation persists, the Fed could institute rate hikes as early as its next meeting in August.
Yet those investors with the equity or debt relationships necessary to buy assets while credit is tight and prices are still in flux will at least find few competitors vying for their deals. Buyers who cull through properties on the market may come across genuine bargains realistically priced by motivated sellers.
Hanson of Grubb & Ellis points out that a real estate market in disruption provides an excellent hunting ground. “Dislocation in the marketplace for commercial real estate is really the catalyst for opportunity.”
Matt Hudgins is an Austin writer.
YEAR-END PREDICTIONS FROM NOTABLE ECONOMISTS
NREI asked four forecasters to predict the near-term direction of key indicators. Here are their responses:
Chief Economist, Grubb & Ellis
“Expect several quarters of rising office vacancy rates. Along with that will be softening asking rental rates, and the pendulum will swing away from the landlord's market.”
Chief Economist, Reis
“Being the single- largest consumer of oil and gas in the world, slightly falling demand in the United States is significant and it will play into world oil prices.”
Chief Economist, Associated General Contractors of America
“I'm an incurable optimist. I think we will start seeing improvement in residential construction and still be on the plus side for non-residential jobs.”
Chief Economist, Parsec Financial Management
“It will certainly be the spring of 2009 before financial markets go back anywhere near where they were in 2003 or 2004.”
GDP growth rate: 1%
Core CPI inflation rate: 2.4%
Monthly job creation: -50,000
10-year Treasury yield: 4.5%
Crude oil price: $85 per barrel
GDP growth rate: 1.1%
Core CPI inflation rate: 2.5%
Monthly job creation: -50,000
10-year Treasury Yield: 3.9%
Crude oil price: $115 per barrel
GDP growth rate: 1.5%
Core CPI inflation rate: 3.2%
Monthly job creation: +10,000
10-year Treasury yield: 3.5%
Crude oil price: $115 per barrel
GDP growth rate: 4.1%
Core CPI inflation rate: 0.9%
Monthly job creation: +119,000
10-year Treasury yield: 4.43%
Crude oil price: $69.78 per barrel
Is a long, U-shaped economic recovery ahead?
While pundits debate whether the U.S. economy will tip into a full-blown recession, commercial real estate investors should resign themselves to the reality that they will be toiling in a flat business environment for the next 18 months. “We're looking at early 2010 before we start to see robust growth,” says Sam Chandan, chief economist at Reis. “That's in contrast with any views toward a sudden rebound this year or in 2009.”
Expect anemic growth of 1% in gross domestic product this year, according to the New York-based real estate research firm. Reis projects a modest recovery to begin in 2009, but GDP won't regain momentum of about 3% annual expansion until the following year. GDP grew at an annualized rate of 1% in the first quarter this year, up slightly from 0.6% in the previous quarter, according to the Commerce Department.
Chandan expects net job losses to the tune of 30,000 per month through the end of 2008 and an unemployment rate of 6%. The job losses will be concentrated in manufacturing and financial services. The unemployment rate increased to 5.5% in May from 5% in April, according to the Bureau of Labor Statistics.
Robert Bach, chief economist at Grubb & Ellis, believes the U.S. is in a recession that will be atypically shallow but long lasting. “Maybe what we're seeing is a flat economy,” he says. “I don't see anything spurring the economy or the demand for commercial real estate for the next year and a half.”
Josh Scoville, director of strategic research at Property & Portfolio Research, also thinks a recession is under way but that the economy will gain some momentum with annualized GDP growth of about 2% by the end of 2008. For commercial real estate, that suggests tenant demand for space will continue to be weak. Absorption already has decreased 25% to 40% in 2007 across the various property sectors, according to Scoville.
“The scenario that is a growing possibility is a long U,” Scoville says. “The recession is mild, but it lasts six quarters. That's not a fun scenario for anybody because there's not a lot of opportunities created and there's not a lot of ways to make money.”
— Matt Hudgins