Inflation, Cap Rates, & US Treasuries. How Are They Connected?
What is Inflation?
Inflation is the price increase of goods and services over time. To maintain a stable economy, the government has set the target of 2% inflation per year.
This means that something that you can buy for $1 today will require $1.02 dollars next year. “The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.” - Investopedia
According to the US Bureau and Labor Statistics, “In August, the Consumer Price Index for All Urban Consumers increased 0.1 percent, seasonally adjusted, and rose 8.3 percent over the last 12 months, not seasonally adjusted).”
Using our earlier example, if you bought a cheeseburger for $1 in August 2021. That same cheeseburger would cost you $1.08 dollars in August 2022. Goods and services are getting more expensive faster than what the government deems as comfortable (8% actual inflation rate vs. 2% target inflation rate).
One goal of investors is to match/beat inflation so that their money’s worth at least the same (in terms of purchasing power) as it was worth 12 months ago. This means that investors needed to earn 8.3% on their investments from August 2021 to August 2022 in order to keep pace with inflation.
There are a plethora of options that investors can buy. This blog will focus on two: commercial real estate properties and US Treasuries.
What is Commercial Real Estate Capitalization Rate?
From a previous article, “cap rate, short for capitalization rate, is a key metric in commercial real estate. As the ratio between a property investment’s net operating income and its open-market value, cap rate is a measure of how much a property’s prospective cash flows are worth in combination with the level of risk. Two buildings can have the exact same amount of income, but the one that is considered less risky will be worth more. We’ll see that “priced in” as a lower cap rate... Consider this scenario: an investor buys a cash-flowing multifamily property, current NOI $400,000, for $10,000,000, which is a 4% cap rate.”
Put another way, this property purchased for $10,000,000 is earning 4% per year (solely looking at cashflow).
What are US Treasuries?
US Treasuries (UST) are bonds issued by the federal government and are considered to be one of the safest assets that investors can buy since they are backed by the "full faith and credit" of the U.S. government. Below are some examples of different USTs as of 10/2022.
An investor can choose to buy a UST that matures in 1 year and pays 4.42% or they can also buy a UST that matures in 10 years and pays 3.88% per year over the 10 years.
How is it All Connected?
Inflation running at 8.3% is considered dangerous to our economy and causes a waterfall of harmful effects.
- Prices become unstable because they rise too fast for wages and investments to keep up.
- When wages and investment cannot keep up with inflation, the public becomes poorer and are no longer able to afford what they could last year.
- The Federal Reserve tries to combat inflation by increasing rates (more on this concept here).
- As rates increase, borrowing becomes more expensive, and the economy slows down since it cannot use debt as easily to fuel growth.
- Since companies cannot grow as easily, they turn their focus on cost cutting measures.
Bringing this back to commercial real estate, rising inflation makes it harder to buy CRE assets from purely a cash flow perspective.
- Inflation has led to treasury rate increases.
- Treasury rate increases make borrowing more expensive.
- Treasury rate increases also make buying CRE less desirable when assessing purely from a cash flow perspective (i.e. Why buy a riskier CRE asset earning 4% when I can buy a safer UST that also earns 4%?)
- CRE activity (investment sales) slows down (WSJ - “Commercial Property Sales Slow as Rising Interest Rates Sink Deals”)
It’s not all doom and gloom. There are always options and where there is a will, there is a way. An old mentor once taught me, “there is never a bad deal, there is only a bad price.” Sellers will need to come to terms with the changing market environment and be willing to accept lower offers or hold their property until the next cycle. Investors will have to update their business plan to seek more value-add strategies with more conservative underwriting.
Good luck out there my friends.
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