Does Inflation Have a Silver Lining?

By Bob Bach, Grubb & Ellis Co.

Yet another gap is opening between Main Street and Washington, this one involving inflation expectations. Federal Reserve officials have repeated again and again that they don't think inflation will take hold anytime soon because there is so much excess capacity weighing down the economy in the form of unemployed workers, too many houses, low rates of factory utilization and vacant commercial space. Most mainstream economists agree with that assessment. Yet when I speak with individual investors, I always ask for a show of hands on whether they think inflation will become problematic in the next year or two, and nearly everyone in the room raises a hand.

Yet another gap is opening between Main Street and Washington, this one involving inflation expectations. Federal Reserve officials have repeated again and again that they don’t think inflation will take hold anytime soon because there is so much excess capacity weighing down the economy in the form of unemployed workers, too many houses, low rates of factory utilization and vacant commercial space. Most mainstream economists agree with that assessment.

Yet when I speak with individual investors, I always ask for a show of hands on whether they think inflation will become problematic in the next year or two, and nearly everyone in the room raises a hand. Households are feeling inflation in the form of higher gas and food prices, and businesses are seeing it in higher input prices for their products.

I’m in the let’s-wait-and-see camp, but if you twisted my arm, I would tell you that I’m in the low-inflation camp. Sustained high oil prices in a moderately growing economy with a glutted labor market are more likely to result in slower growth than higher inflation. There’s not enough momentum for the economy to keep pushing ahead against the friction of higher oil prices. But, like I said, I’m keeping an open mind for now.

If we do get higher inflation, it wouldn’t be a bad thing for commercial real estate, which is viewed by investors as an inflation hedge. Leases usually are written with annual rent bumps often tied to the consumer price index or a fixed rate of increase. And as construction costs rise, as they have been lately, the cost to replace existing properties also rises.

During the last serious bout of inflation in the U.S. 30 years ago, commercial real estate returns as measured by the National Council of Real Estate Investment Fiduciaries handily beat the consumer price index even though the early 1980s saw back-to-back recessions, the second of which in 1981 and 1982 was severe. It’s worth remembering that real estate lets investors hedge against inflation, which could be one reason for the 120-percent gain in the dollar volume of commercial property sales transactions last year compared with 2009.