8.6% Inflation Means Serious Planning for CRE

The CPI calculation—consumer price index, or what’s commonly called inflation—was expected to run warm, but not like a Miami August afternoon on the beach without an umbrella for shade.

“A Labor Department inflation report proved many traders were wrong with identifying peak inflation,” wrote Edward Moya, senior market analyst for the Americas at OANDA, in a note.  “Everything came in hot [Friday] with today’s CPI data, the monthly core reading, the headline number, and a much stronger dollar will further fuel inflation here.”

Or, as Sean Bandazian, a senior investment analyst at Cornerstone Wealth, told Business Insider, CPI was “stunningly high.”

The news has a number of significant and potentially troubling implications for the CRE industry.

Start with interest rates. Those who hoped the Fed might see a cooling in inflation and hold off on some future rate hikes are likely to be disappointed.

“The surprise increase in headline inflation to 8.6% in May, from 8.3%, together with another strong rise in core prices raises the odds that the Fed will need to extend its series of 50bp rate hikes into the fall, and even opens the door to a larger 75-bps move at next week’s FOMC meeting,” Michael Pearce, senior U.S. economist at Capital Economics, told Reuters.

As if rising rates weren’t enough problems in CRE. Historically, a slight increase isn’t the worst the industry has seen. But the runup to inflation was riding on incredibly cheap money. Even now, interest rate caps alone are causing many transactions to evaporate. Those, and the ultimate rates themselves, are only going to get larger, making the dynamics of investments and projects trickier, in turn putting downward pressure on prices.

CRE sales are already beginning to slow. That will likely continue. But there may also be an increase in some sales, possibly at distressed pricing, because the five-year refinancing rule of thumb says that in any given year, 20% of deals will need to be refinanced. If the existing operating dynamics were built on low interest rates, higher ones could make them untenable.

Then there are direct and indirect effects of inflation. To date, the producer price index for construction, which doesn’t include labor or land, has been running about three times as high as the CPI. Will that differential continue/? Perhaps not, but if there is an effect, the roughly 20% to 21% year-over-year increase will push building costs up even more.

As for the indirect issues, there are all those companies leasing space and consumers renting apartments and houses. Higher inflation means tougher times all around. Consumers, in particular, are glum. The University of Michigan consumer sentiment numbers crashed, approaching the figures for the depths at the end of 2008. As Jeffrey Roach, chief economist for LPL Financial, wrote in a note on Friday, “The crash in sentiment means that consumers are more and more worried about future economic conditions. Consumers are more pessimistic about future income with overall sentiment at the lowest on record going back to 1978.”

This is seriously glum. If consumers are right, they’re going to pull back on everything and may not have the money to keep up with rent increases. Landlords and operators may find themselves with challenging circumstances and no government help this time if there are widespread problems in people lacking the money to pay for their housing.