As the economy chugs along with rapid growth in the economy, post COVID, our economists are often concerned about Inflation. A simple definition of Inflation is: a general increase in prices and fall in the purchasing value of money.
Our current generation hasn’t seen much inflation above 2-3 percent. Historically, the big jumps in inflation where after World War II as the economy boomed post war (double digits in 1947) and briefly in 1974 (think oil embargo and the impact of petroleum price on many consumer products). So, what’s the big deal about inflation and real estate in particular, and why could we be concerned?
Inflation exerts will tell you that in an inflationary economy, some of the best investments to make are in gold and real estate. Let’s look at real estate and inflation’s impact.
Current Owners of Real Estate
One metric of consideration in real estate investing is replacement cost. Simply put, the amount you will pay for real estate is a factor of what it would cost to build it today. On the same corner of Main and Main, if you had a building that you bought at $100/sf ten 10 years ago and the site next door was just built new at $200/sf…which one would you buy if the rents were the same? By the very nature of inflation, the current owners of real estate could have a competitive edge based on their cost basis relative to replacement cost. Why build new when you can buy next door? Better said, what was once $100/sf has gone up considerably because of what it takes to build new. Existing owners relish inflation on these very simplistic terms.
Developers of New Real Estate
Our developments are at risk when inflation occurs. In the real-world case below, because of inflated lumber prices (in part), our project had a “pause,” as costs required us to “restructure” our offering. We underwrote certain rents, which attributed an underlying value and in turn facilitated a need to restructure our capital in a manner that was feasible. When preliminary construction prices came back, the assumptions needed to change: 1) We needed higher rents – which was not going to happen…the market is what it is; 2) We needed more equity and debt to make up for the increase in costs and 3) All the documents to do the deal had to be rewritten and approved through various entities, lenders, and authorities that need appeasing. The eleven (11) attorneys on the deal were very happy to rewrite our documents.
The Coming Disaster
Reviewing the graph below outlines the effect of inflation of over period of time on the spending power of a dollar (read the definition above again).