Looking at Real Estate in an Era of Inflation, or Deflation

Bob Bach, Grubb & Ellis The level of paranoia about the economy and the financial markets is high and rising. Wasn't it just a week or two ago that the financial media was trumpeting the threat of inflation due to the epic budget deficits? Now the discussion has pivoted to deflation, the role it played in Japan's lost decade of the 1990s, and the potential for it to take root in the U.S.

The level of paranoia about the economy and the financial markets is high and rising. Wasn’t it just a week or two ago that the financial media was trumpeting the threat of inflation due to the epic budget deficits? Now the discussion has pivoted to deflation, the role it played in Japan’s lost decade of the 1990s, and the potential for it to take root in the U.S. Though the broad economy can’t have inflation (rising prices) and deflation (falling prices) at the same time, the two aren’t mutually exclusive. Healthcare costs are rising at the same time that housing prices remain weak, for example. And we could see a bout of deflation followed by inflation when the private sector begins expanding at a faster pace.

The imbalances in the economy that could lead to such a scenario are real. Nevertheless, it’s a sign of the times that people can pivot so quickly from worrying about one to the other. What about a scenario where the economy continues to expand at a moderate pace, strong enough to avoid deflation but gradual enough to keep inflation from overheating? People seem much more willing to believe the economy will drive into the ditch on one side or the other and much less willing to believe that it can keep all four tires on the road.

Whether it’s inflation or deflation, commercial real estate looks to be a popular alternative for investors. Long regarded as an inflation hedge thanks to its performance during our last serious bout of inflation in the early 1980s, commercial real estate is benefitting from the low interest rates and disinflation (declining inflation) that define the current economic landscape. Investors are willing to pay up for the best, most competitive assets that are well-leased with low rollover risk, the most recent and visible example being the 1.3 million-square-foot office building at 300 N. LaSalle in downtown Chicago. KBS purchased this property for its non-traded REIT for a price of $655 million, a record $500 per square foot.

Real Capital Analytics has cited more prosaic examples where investors will pay up for top-of-the-market assets while similar properties in the next lower tier, just down the road, go begging. Even at high prices, the best properties look like winners compared with other asset classes – the uncertain outlook for stocks, and bond yields that are barely visible. Added to commercial real estate’s reputation as an inflation hedge, it’s a surprising performance in an era where disinflation is the norm and outright deflation could be a possibility.