By Martha Peyton, PhD, Aegon Asset Management
Inflation has been dormant for at least the last two decades rarely rising above a 2% annual rate. While out-of-sight, it is never out-of-mind especially in financial markets. Over the last few months, inflation fears have been bubbling up as seen most vividly in the 50-basis point pop in the five-year US Treasury yield between 0.38% at the beginning of the year and 0.88% at its recent peak at the end of March.1 With this backdrop, commercial real estate (CRE) investors are pondering the historical inflation hedging power of property but also the prospects for higher borrowing costs should inflation take hold. In this paper, we support a conclusion that inflation fears are excessive; commercial mortgage financing is abundant; and attention to the very positive prospects for economic growth is well-advised.
Investors cite inflation hedging power as one of the primary attractions of property investments.2 This characteristic has been of limited use in recent years given the very low pace of inflation in the US and throughout most developed global markets leaving other factors to drive real estate’s investment allure. Currently, inflation fears are emerging and raising concerns regarding potential negative effects on discount rates used to value portfolio properties as well as potential positive effects on property cash flows.
Inflation expectations demonstrated in financial markets are minimal
The best indicator of inflation expectations is the yield on Treasury Inflation-Protected (TIPS) bonds. These instruments are traded continuously in deep liquid global financial markets thereby providing a real time window into market views of inflation prospects. Yields on TIPS are credible indicators of inflation expectations because they represent actual financial transactions rather than opinion surveys. Investors in TIPS are betting money on the path of future inflation.3
As shown in Exhibit 1, inflation expectations have been increasing especially since mid-January. The increase reflects the projected enactment of the $1.9 trillion American Rescue Plan Act signed by President Biden on March 11. The plan is on top of the similarly-sized Coronavirus Aid, Relief, and Economic Security (CARES) Act signed in March 2020 and the $0.9 trillion follow-up signed in December 2020. The combined package is directed at supporting the economy through the Covid-19 recession that began in March 2020 with extensive shutdowns in economic activity to quell contagion. The five-year US Treasury yield dropped precipitously in March 2020 along with expected inflation as the economy tanked; high quality corporate bond yields behaved in similar fashion. With the enactment of the support legislation and the vigorous distribution of Covid-19 vaccines, economic recovery is in sight. Yields are now picking up in response with inflation expectations of roughly 2.5%. Inflation fear may be stoked further in coming months as Congress considers the President Biden’s infrastructure spending proposal.
Exhibit 1: Inflation expectations increasing
Source: St. Louis Federal Reserve Economic Data as of March 31, 2021
These expectations are in line with the US Federal Reserve (Fed) policy which is targeting a period of above 2% inflation designed to super-charge job creation. The Fed focuses on prices of personal consumption expenditures excluding the volatile food and energy categories. Economic projections of Fed policymakers show a range up to 2.5% in 2021 and 2.3% in 2022 but averaging 2.0% in the long run.4 Similarly, the forecasters polled in the monthly Blue Chip Economic Indicators Survey project steady 2.1% personal consumption expenditure (PCE) inflation throughout a long-term ten-year window.5 As shown in Exhibit 2, inflation has rarely breeched a 2% rate over the last twenty years. Altogether, forecasters are expecting a very modest pickup in inflation in line with monetary policymakers’ expectations and history. Aegon Asset Management’s expectations are similar.6
Exhibit 2: Inflation below 2% for most of the past two decades
Source: St. Louis Federal Reserve Economic Data as of February 1, 2021
Effects on CRE through borrowing costs
If property cash flows and values were driven simply by yield arithmetic, the uptick in inflation and interest rates might produce negative effects similar to the negative effects on bonds. But property cash flows are not fixed; they respond to economic growth and supply-demand drivers. The federal spending directed at Covid-19 relief is putting upward pressure on interest rates and inflation expectations precisely because it is supporting economic recovery.
At the same time, re-pricing of commercial mortgage borrowing could have a negative effect on levered property performance, but this needs to be netted against the positive impact of stronger and faster economic recovery. In addition, it is important to note that commercial mortgage pricing did not respond fully to the Covid-related drop in US Treasury yields. According to the American Council of Life Insurers (ACLI) and shown in Exhibit 3, life company commercial mortgage spreads actually widened as the Covid recession took hold in the third quarter of 2020. Lenders apparently viewed the drop in US Treasury yields as a transitory shock and widened spreads in response. This leaves a cushion for a return to more normal US Treasury yields as recovery ensues. As shown in Exhibit 3, the five-year US Treasury rate peaked at 2.88% in the fourth quarter of 2018, meandering downward though the first quarter of 2020 and then plunging in the second quarter of 2020 as the Covid shock prompted the Fed’s rapid and strong policy response. Commercial mortgage loan (CML) spreads widened markedly at that time after holding in the 150-200 basis points range over the prior five years. Over that period, the low point in spreads hit 144 basis points in the third quarter of 2018. In the final quarter of 2020, spreads were 88 basis points wider than that low point which had a corresponding five-year US Treasury rate of 2.81% versus the 0.37% US Treasury rate in the fourth quarter of 2020.
Exhibit 3: Life company commercial mortgage vs. 5-year Treasury spreads widen in third quarter of 2020
Source: St Louis Federal Reserve Economic Data as of March 31, 2021, American Council of Life Insurers as of December 31, 2020.
Arithmetically, this history implies a substantial cushion in CML spreads to absorb rising interest rates as Covid recovery progresses. But actual spread pricing depends on more than arithmetic; it is enormously influenced by the competition among lenders for CML origination business. Life insurance lenders committed almost $16 billion in the fourth quarter of 2019, the highest commitment total since the beginning of the post-global financial crisis (GFC) cycle. Appetite reflected the availability of CML and pricing that remained attractive versus other fixed income assets offering comparable risk. Commitments plummeted as the Covid recession took hold reaching a cycle low of $5.9 billion in the second quarter. But evidence of durable appetite for the period ahead is suggested in a strong uptick in commitments to $10.9 billion for the fourth quarter as Covid vaccines were approved.
Beyond life insurance, lenders’ further demand for CML lending opportunities will likely come from securitizations and private equity debt funds. CMBS securitizations are tracking close to pre-Covid pace; “Commercial Mortgage Alert’s” April 16, 2021 publication reported year-to-date issuance of $20 billion in the US versus $21.6 billion for the same period in 2020. For private equity debt, a recent report dated March 30, 2021 shows a cache of dry powder of $250 billion that will need to be activated in the months ahead to generate returns.7 Commercial banks will also compete for CML business but their appetite is usually focused on shorter maturities and construction lending.
A final note on inflation, rising interest rates and inflation are the result of stronger economic growth. Under the Fed’s new policy rubric, inflation above 2% will be tolerated on a temporary basis to strengthen job creation and economic growth. Stronger economic growth is the most powerful driver of CRE performance. So, we believe that even if borrowing costs rise, revenues should offset some if not all of the pain.
Effects on CRE through lease structure
Beyond the question of borrowing costs under a regime of rising inflation, there are reasons why CRE has been and will likely continue to be considered an inflation hedge. First, investment performance has beaten inflation over medium five-year holding periods for the past forty years with the exception of the 1990’s recession and its aftermath. This result is shown in Exhibit 4 using total return on the National Council of Real Estate Investment Fiduciaries (NCREIF) National Property Index (NPI) minus the Consumer Price Index (CPI) including food and energy. Similar results are obtained using the core PCE price index to measure inflation. CRE performance beat inflation even during the more severe recession associated with the GFC. Recession itself does not undermine the inflation hedging power of CRE which rather depends on the supply-demand balance in property markets when recession takes hold. The five-year holding period reflects the relatively long investment horizon associated with property that is necessitated by the relatively high transactions costs.
Exhibit 4: NPI total return vs. inflation, five-year rolls
Source: NCREIF, US Bureau of Labor Statistics as of December 31, 2020.
Second, commercial property returns are influenced by the structure of leases where some inflation protection can occur from triple-net leases that pass property expenses to tenants (especially for industrial property), inflation step-ups that index rents (especially for office properties), short-term leases that can be adjusted to compensate for inflation (especially for apartments), and common area maintenance (CAM) passthroughs that are prevalent for regional mall retail. It bears noting, however, that these lease structures did not prevent the shortfall in property performance versus inflation in the first half of the 1990’s because more powerful supply-demand forces were out of balance.
Third, inflation mitigation can arise from investor behavior when expectations of rising inflation encourage investment in property expecting it to hedge inflation. Rising investor demand, in turn, can generate increasing values that may indeed hedge inflation in a self-fulfilling prophecy. If rising inflation does materialize and is associated with stronger economic growth, the bet on property will be rewarded and vice versa.
Looking ahead
We believe CRE performance in all sectors should benefit from the recovery in economic growth as Covid vaccinations bring contagion under control. Forecasters predict real GDP growth to average 6.3% in 2021 and 4.3% in 2022.8 Inflation in both years is expected to reach or slightly exceed 2% with the periods slightly above 2% within the Fed’s tolerance.
Strong economic growth will impact commercial property sectors differently: apartments will benefit as job creation boosts demand especially by stimulating household formation; industrial will benefit from increased consumer and investment spending boosting demand for warehouse space but offset somewhat by revival of in-person shopping at stores which will benefit the retail sector; office will benefit from returning tenants with impact of work-from-home policies highly uncertain. In addition, the lodging sector will benefit mightily as travel resumes. Each sector will face local market challenges as the pattern of geographic growth and post-Covid behavior emerge. The modest construction over the last few pre-Covid years will help to buoy investment performance but, as always, investors will need to select properties and manage portfolios carefully.
The outlook is complicated by the potential for a material increase in federal spending from President Biden’s infrastructure proposal now under discussion. The $2 trillion proposal would be spent over eight years and paid for largely by raising corporate taxes. On a positive note, US infrastructure is in dire need of attention, in the American Society of Civil Engineers’ Report Card for America’s Infrastructure, 2021, a $2.6 trillion shortfall is estimated over the next ten years unless the current pace of infrastructure spending is boosted. In addition, the need for improvements in clean energy generation, cybersecurity and public health preparedness add to the $2.6 trillion gap. Over the long term, infrastructure investment might also improve productivity and jump start private sector innovation which are both are positive for economic growth and for real estate. The eight-year time frame for projects is important to note because it will spread out the demand for labor and materials and mitigate short-term inflation increases as pent-up demand is addressed in the aftermath of the recession.
References
1St. Louis Federal Reserve Economic Data, March 31, 2021
2Pension Real Estate Association, Why Real Estate? Why Real Estate Q4 2020
3Some analysts are discounting the efficacy of TIPS as indicators market inflation expectations because the Fed has been buying them as part of the Covid-19 quantitative easing program. These concerns are countered by the steadiness of the Fed’s purposes throughout the recent increase in inflation fears suggesting that market participants are not fighting TIPS yields resulting from the Fed’s actions.
4US Federal Reserve Summary of Economic Projections March 17, 2021, Core Personal Consumption Expenditures
5Blue Chip Economic Indicators, March 12, 2021
6“Inflation Outlook”, April 2021, Frank Rybinski, CFA and Harris Kere, CFA, Aegon Asset Management
7The Real Deal, online, March 30, 2021
8Blue Chip Economic Indicators, April 9, 2021
