How Long Can Consumers Hang On?

When things are tough and a player’s performance takes a tumble, coaches send in a substitute. That’s exactly what consumers are doing under the pressure of the highest inflation rates in 40 years.

It’s called, aptly enough, the substitution effect by economists. When finances are tough for people, they trade down in price by substituting a cheaper choice. That’s happening in basics, which raises the question of how long it can be before consumers look for cheaper digs because they can’t afford escalating rents or housing prices.

Consumer confidence in current conditions and future expectations is considerably lower than even the early worst times of the pandemic in April 2020, according to Morning Consult’s regular Consumer Confidence Dashboard survey series. And as JP Morgan Chase noted a couple of months ago, “Facing the most rapid price increases since the early 1980s, many US households are facing difficult choices, including whether to change purchasing habits or dig into savings.” If fuel, rent, and food prices kept rising, the bank said before those prices did exactly that, “we might see sustained changes in household spending.”

“Retail sales are reflecting Americans’ growing concern about inflation and its impact on the cost of everything from groceries to gas,” said National Retail Federation president and CEO Matthew Shay in a June 15 statement.

People are already substituting. In a May earnings call, Kohl’s CEO Michelle Gass noted “bifurcation” in the company’s customers. Some were spending more on premium brands and “then you also see, though, a lot of customers going to the private [store] brand.” Which is cheaper.

Kroger’s in its most recent earnings call noted that its store brands sales saw 6.3% growth in the first quarter of 2022, versus 4.1% for all of its sales minus fuel.

So, people are trying to tamp down spending because they don’t have enough money. Inflation has been climbing and, in May, average earnings after inflation were down 3.9% year over year, as shown by Bureau of Labor Statistics data.

And that brings the country, and the CRE industry, to what is traditionally the largest component of the theoretical market basket used to measure price changes and inflation: housing. Fannie Mae projects that housing will continue to be a drag on economic growth through 2023.

“While consumers’ resilience to the predicted financial stress remains an open question, the ESR [Economic and Strategic Research] Group now forecasts personal consumption growth to slow from 4.2 percent in Q2 2022 to 1.9 percent and 1.3 percent, respectively, in Q3 2022 and Q4 2022,” it said in a June 16 analysis. “Residential fixed investment, driven in part by an even further reduced home sales forecast, is projected to decline 8.6 percent in 2022 and 6.5 percent in 2023 – the largest percentage declines among the major GDP components.”

“The significant, sudden rise in interest rates is beginning to be felt widely as employment growth slows and stock market valuations fall,” said Doug Duncan, Fannie Mae senior vice president and chief economist. “Nowhere is this more evident than in housing affordability measures, with the prospective monthly payment on a typical new mortgage climbing dramatically. As a result, both new and existing home sales continue to slow, while refinance activity has fallen substantially, with what’s left largely consisting of equity extraction.”

Or, as Enrique Martínez-García, a senior research economist at the Federal Reserve Bank of Dallas, told Fortune, “This might be a housing bubble. The evidence suggests it looks like a housing bubble.” Might is different from is, but it’s become increasingly clear to many in the industry that many millions can’t afford to stay on the rent and house price escalator. Gas to get to work is expensive. Food’s expensive. Medicine’s expensive. Eventually, when it comes to substitutions, there won’t be many other choices left. A broad-based movement to less expensive housing, in a market where investors keep betting that rents will rise to make up for high property prices, could take a hammer to valuations.