Economists of all stripes agree that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. Given QE2, the unfathomable amount of US government debt (inclusive of Social Security obligations), and lack of job growth, how, one might ask, can we not anticipate runaway inflation in the United States?
Yet, the expected inflation rate is remaining low by historical standards. Investors are not seeing inflation risk, at least as evidenced in the capital markets’ pricing of Treasuries.
Investors believe in the Federal Reserve’s ability to keep inflation low. As Uber-E-Commentator John Mauldin argues, the history and idiosyncratic structure of the US Federal Reserve system is a bulwark against inflation, so long as the Fed remains independent of the Federal Government.
Furthermore, the devaluation of major assets classes such as homes, mortgages, bank loans and CMBS pools also dampen inflation expectations. While higher commodity prices and fuel prices are impacting your grocery shopping, asset devaluations and 9% unemployment may be sufficient to tame inflation.
Looking over the horizon, however, it may be prudent to consider how high inflation may impact your commercial real estate investing. Mortgage debt should be at fixed rates. Although already a standard practice, increases in operating expenses should be passed on to tenants. How about tying annual rent bumps to a cost of living index? Working a COLA provision into leases now, before inflation is a concern, may prove to be a winning strategy.
Commercial real estate investments are outstanding during inflationary times only if you pay a sensible price for well situated assets. If local real estate supply and demand is out of balance, and persistent high vacancy rates (above 15%) exist or are likely, then the opportunity to increase rents and pass on higher expenses becomes less probable.
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BTW: Digressing into a bit of academia, the term inflation risk is not about expected higher prices. If the economy consistently has prices increases of, say, 2%, there is not any risk. The 2% increase is simply factored into the cost of business, bonds, capital, and purchasing behavior. The trouble occurs when expected inflation deviates from reality. An investor may price 2% inflation to calculate his nominal five-year yield expectations, and be unhappy with the results (and poorer) when inflation jumps to 4%.
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