Some of you may remember the early 1980’s run-up of inflation that ran into double-digits. If you do, you’ll also remember what happened to interest rates when Fed Chairman Paul Volcker intervened to get inflation under control.
It was ugly to say the least.
Mortgage rates for commercial property loans exceeded 15%, and that put the brakes on transaction volume and value appreciation. Owner/user purchases just didn’t make sense and industrial market activity came to a virtual standstill until a massive tax cut was passed that included accelerated depreciation benefits to offset those high mortgage rates. A recovery ensued until the savings and loan industry collapsed, sending the real estate industry into a massive correction in 1989. It was a roller coaster ride that we wouldn’t recommend to anyone.
Are we heading in that direction again? That’s a hotly debated question of late. The Fed, after years of monetary stimulus aimed at getting inflation up to 2%, may have bitten off more than it can chew, as its key inflation index, the Personal Consumption Expenditures (PCE) hit 4.2% in July. The Consumer Price Index, (which includes food and energy) was up 5.4% year-over-year. Jerome Powell, the current Fed Chairman, has told us that the spike in inflation is likely transitory as the economy emerges from the pandemic recession. But, he is in disagreement with a lot of economists who have been warning of higher inflation due to the massive injection of “new” dollars into the economy. The federal government has spent trillions in pandemic relief and is poised to inject trillions more with the American Families Plan that may come to a vote as early as the end of September.
The Fed is buying $120 billion in US Treasuries and Mortgage-backed Securities every month and its benchmark Fed Funds Rate is sitting at 0% to .25%, as it continues its efforts to stimulate economic growth. But, if inflation continues on its current trajectory, it will be forced to slow its bond-buying and jack up interest rates to fend of inflation. That means the cost of capital would rise, including mortgage rates that have been a primary driver in the run-up in real estate values over the past 10 years. Combine that potential action with a massive tax hike on capital gains, a severe limitation on 1031 exchanges and the taxing of capital gains at death, and we could have a real conundrum on our hands.
We bring this to your attention because we believe it is important to all of us, but particularly to you and your current investment strategy. A thorough review of that strategy is in order and the time for it is now. Our hope is that the American Families Plan’s tax hikes are defeated and Mr. Powell is correct in his assessment that the inflationary spike is transient. Like you, we would like to see the commercial real estate market continue to thrive. But, we all need to be prepared for a change in direction. If it doesn’t happen, great. If it does come our way, having alternatives could mitigate the impact of a market correction on your portfolio.
Our recommendation to those who have plans to dispose of real estate assets in the next 5 years is to immediately meet with trusted advisors to review their current posture. There is less than four months remaining to acquire, exchange or exit real estate assets under the current tax code, assuming the American Families Plan makes it to the President’s desk. If it does, it will be at least 5 years before it could be undone given the current political landscape. If it does pass, many short to intermediate term holders of real estate will probably shift back to a long term hold strategy. Also, real estate as an asset class will be less attractive, which would certainly impact buyer demand and pricing.
Let’s hope that inflation settles back into a range the Fed is comfortable with and it can slowly wean the economy off current levels of monetary stimulus. That, coupled with the defeat of proposed tax hikes that directly impact commercial real estate, would be our preferred outcome. In the meantime, we recommend that you prepare for the worst while hoping for the best.
Please give us a call if we can help you evaluate your real estate’s value and strategic position in the market.