With wholesale inflation jumping a record 9.6% in the past 12 months, its fastest pace in nearly 40 years, we can all agree the Fed has failed. Inflation is a choice. It’s a choice for which the Fed is chiefly responsible.
The risk of an inflationary spiral arose when policy makers first chose to ignore it, then cast blame elsewhere. It is only compounded by the White House insisting it will soon fade away. This is in spite of the fact Fed Chair Jerome Powell officially retired the term “transitory” in recent testimony.
The question is, how bad will it get? In our opinion, very bad. This is because the monetary and fiscal mistakes of the Fed and White House are followed hard on by a punitive Biden Administration regulatory agenda that “virtually ensures that the post pandemic economy will be nothing like it was before.” (WSJ 12/14/21).
The administration’s attack on business is widespread. Whether specific to finance, banking, manufacturing, energy, etc., this mounting regulatory burden and its open hostility to wealth creation will surely stifle the animal spirts necessary to drive any meaningful recovery.
As Phil Gramm and Mike Solon recently said in the WSJ, “All the ingredients will be present to turn the current inflation into stagflation.” For those of you too young to have experienced it firsthand in the ‘70s and ‘80s, stagflation is a term used to describe slow economic growth at a time of high inflation, the worst of all possible worlds.
What then, do rising interest rates catalyzed by inflation and a slowing economy crippled by regulatory over-reach mean to income property investors? First and foremost, investors will demand higher cash-on-cash returns from property programs.
This scenario is already playing out in the manufacturing sector with unions demanding significant wage increases and the inclusion of COLA or Cost-of-Living Adjustment clauses in their contracts. COLAs have been largely absent form labor negotiations for over 30 years.
This is a bell-weather event as it signals expectations regarding future inflation. Once in place, they are historically hard to dislodge and inflation tends to take on a life of its own.
It only makes sense then that real property investors will demand the same sort of increases in future rental income streams to protect them against an erosion in the purchasing power of their dollars.
This expectation should work to the benefit of operating assets. Operating assets are those properties with multiple tenants and short lease intervals: multi-family, senior living, self-storage, manufactured housing, etc. Due to their short lease intervals, 1 month to a year, these assets give landlords the opportunity to increase rents as frequently as possible.
Depending on how bad inflation gets, this flexibility may mean the difference between making or losing money on a property at time of sale. Assuming full occupancy, this has the potential to enable landlords to meet future investors demand for inflation driven higher cash flows.
In our opinion, these same circumstances may work to the detriment of single tenant triple net lease assets. This is because there is often a tradeoff between the perceived security provided by a long term corporate tenant and ability to increase rents on an as needed basis. Rent rates are usually predetermined in these leases. In so doing, it limits landlords ability to change according to marketplace exigencies.
This is well and good in an environment characterized by low interest rates and stable prices. However, we appear to have left that and look to be entering an environment potentially characterized by price volatility and rising interest rates.
It is a brave new world and real property investors must adapt if they are to protect and grow their hard earned sweat equity. If they don’t, they run the very real risk of seeing the fruits of their labor inflated away by an overly indebted nation and its profligate government.