The federal reserve on multiple occasions has called the recent spike in inflation “transitory” yet inflation just rose to its highest level since 1982.  Will inflation increase over the short term and then fall to a much lower level in the future?  Why is the answer to the inflation question so important for real estate?  What real estate factor will drive inflation?  What is the CPI index telling us about the future?

 

What is inflation?

Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.

Do not think of inflation in terms of higher prices for just one item or service, however. Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy. The chief measures of U.S. inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.  Both the CPI and PPI have showed impressive gains the last quarter rising well above the mainstream forecasts.

Some inflation is a good thing, but a huge jump in inflation, like we are seeing now, is not good for the long-term prospects of the economy.

What was in the recent inflation metric (Consumer Price Index)

U.S. consumer prices climbed in April by the most since 2009, topping forecasts and intensifying the already-heated debate about how long inflationary pressures will last.

The consumer price index increased 0.8% from the prior month, reflecting gains in nearly every major category and a sign burgeoning demand is giving companies latitude to pass on higher costs. Excluding the volatile food and energy components, the so-called core CPI rose 0.9% from March, the most since 1982, according to Labor Department data Wednesday. The gain in the overall CPI was twice as much as the highest projection in a Bloomberg survey of economists.

It even caught the federal reserve off guard with the Fed Vice Chairman Richard Clarida saying after the consumer price index report “I was surprised”.

What is the consumer price index?

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.  Essentially it takes a group of products and services and tracks their movement over a period.  They measure the changes for specific items like used cars, rent, airline tickets, etc.. and give each one a weight.  Below are the biggest contributors in the “basket of goods and services” to the Consumer Price Index. (source: US bureau of Labor and Statistics)

  1. Food 14%
  2. Energy 7%
  3. Commodities (less food and energy) 20% (6.5% of this are new and used cars)
  4. Services 60% ( rent makes up 33% and medical 7%)

Where will inflation go from here?

Unfortunately, I am not sure what data the federal reserve is looking at, but basic statistics are painting a drastically different picture.  As noted above the larges drivers of inflation are rent, cars, food, and medical services.  These four categories make up approximately 61% of the CPI basket of goods. To answer what will happen to inflation we can easily make predictions in each of these categories.

  1. Rent: The recent rent increases are at just the beginning of a huge upward movement in prices. As prices of properties has gone up, so have taxes.  The increase in taxes are “baked into” the rent.  For example in Denver, CO due to the huge appreciation in real estate values, residential taxes will go up 20%+ .  This increase in taxes will flow through to higher rental rates.  Furthermore the maintenance costs have gone up considerably from the costs of new appliances to Carpet to labor to maintain the property.  All these factors will be added into the rental rates and cause rents to continue to climb.  There is nothing on the horizon that will cause rents to drop.
  2. Cars: I think the used car phenom will subside in a year or so after the chip issue allows them to produce more cars. On the flip side as cars continue to become more automated their prices will also increase.  I do not see any let up in this trend.
  3. Food: Food costs have soared as production costs like labor have increases substantially. I do not see labor costs declining any time soon.  Furthermore, because of the covid epidemic many manufacturing changes were made to increase health/safety of workers (less density of workers on assembly lines, etc…) that also substantially increased costs.  We are just now seeing the costs passed on to consumers.  Consumer Price Index data for the month of January found that the cost of food eaten at home rose 3.7 percent from a year ago — more than double the 1.4 percent year-over-year increase in the prices of all goods included in the C.P.I. “Food prices are going to continue to increase for probably a good year, year and a half.” Lempert warned that shoppers shouldn’t expect relief any time soon. “I think food prices are going to continue to increase for probably a good year, year and a half,” he predicted. “Our costs are going to go up for food production,” he said.
  4. Medical Services: In my lifetime I have not seen a decline in the cost of medical services.  My insurance premiums have gone up every year.  Covid has only supercharged the increases as medical companies pass on their increased expenses for upgraded ventilation, reduced capacity, etc…

Long and short, if you look at the four heavily weighted items in the Consumer Price Index, all of them look to continue an upward trajectory, with rent, the largest driver showing the most upside potential with higher rents because of higher property taxes and labor/maintenance costs.

As inflation increases, look for downside pressure on real estate.

The major driver of our recent real estate boom has been rock bottom mortgage rates.  Unfortunately, rates will not stay low forever.  As inflation increases, long term treasuries will also increase and in turn mortgage rates will make large jumps upward.  As rates increase the real estate party will come to a screeching halt as salaries will not keep pace to compensate for the huge jump in payments.  Let us do a quick example: assume you are buying a house in Denver with a median home price of over 600k, you put 20% down so your mortgage is 500k.  Assuming a 2.75% rate your payment is 2041/month.  Now assume the rate goes to 4% your payment is now 2,387/month and that is excluding the higher costs for taxes that you are paying because the property is now valued more, when you add the two together, you are paying almost 500/month for the median home.  This equates to a 25% increase in your housing expenses per year.  I will bet the average person did not get a 25% raise at work this year (excluding the onetime stimulus payments)

Summary

The federal reserve is grossly underestimating the upside surprise on inflation which will force their hand on rates/tapering sooner rather than later.  The federal reserve is playing a dangerous game of chicken by leaving long term rates low for so long.  We will eventually feel the pain throughout the economy as inflationary pressures build.  Furthermore, there will be a “reset” in the real estate market as future buyers are priced out of the market due to higher rates.  There is no doubt based on the primary drivers of inflation that the economy is not transitory, but in transit to higher rates.

 

Additional Reading/Resources:

  1. https://www.forbes.com/advisor/investing/what-is-inflation/
  2. https://www.fairviewlending.com/cpi-jumps-impact-on-rates-and-real-estate/
  3. https://www.bls.gov/news.release/cpi.t01.htm
  4. https://www.nbcnews.com/business/business-news/price-food-gas-creeping-higher-will-stay-way-while-n1259206

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending.  Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine,  The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.