Learn Inuit to Understand Inflation
[The Registry October 2010 Issue]
Urban legend tells us that the Eskimos have more than 100 words to describe snow. That's a lot of different snowflakes! If one of the primary fears of commercial real estate investors is a multiple-year, blizzard of inflation and the accompanying wealth-smothering drifts of worthless fiat currency, then we need more than a single word to describe inflation too. All inflation is not created equal and depending on a real estate investor’s portfolio and cost structure, inflation will impact operators differently.
Monetary inflation is what investors and bondholders fear most. Monetary inflation happens when a sovereign government decides that the easiest way to pay its bills is to print currency. Politically, this is preferable to announcing a tax increase or a currency devaluation, but monetary inflation is the equivalent of a tax and does the job of eliminating a mountain of debt just as well (with no press conference needed). The most striking modern-day example of monetary inflation is the country of Zimbabwe, which experienced inflation at its peak of more than 100 percent per day in the years 2005 through 2008. I keep a $100 trillion Zimbabwe banknote on my desk as a reminder of this very real potentiality here in the United States.
The sneaky thing about monetary inflation in today’s digital economy is that the Treasury need not use any paper or ink. Money is created at the Federal Reserve by moving the decimal place on a balance sheet to create the dollars to buy U.S. Treasuries. But the eventual result of chronic quantitative easing is inflation, which is another form of taxation—that is: buying power is taken from citizens through inflation and used to repay sovereign debt. Monetary inflation's currency tax is highly regressive and impacts citizens quite differently depending on the basket of assets they own and their sources of income.
Baby Boomers dependent on Social Security benefits, annuity payments and bond portfolios will be hit with the highest currency tax. Hyperinflation would effectively strip these Boomers of their net worth. Investors with assets denominated in stronger currencies than the U.S. dollar would fare better. Owning stocks in companies with business models that allow them to increase prices with inflation is one way to hedge. Investors in commercial income property would also benefit if their property can bear rents increased with inflation without losing occupancy.
For commercial property investors, that's not the whole picture, however. Real estate investors using short-term debt to finance acquisitions may find the cost to refinance that debt surprisingly high in an environment of high inflation. Real estate investors who secure a long-term, fully amortizing loan today will benefit from inflation by being able to pay off the debt with ever cheaper dollars, provided the property is able to maintain occupancy and rents increase in step with inflation. An income property that is inflation hedged for both its income and its debt is probably one of the best vehicles available to survive and prosper during times of high or hyperinflation.
Although the United States has never overtly defaulted on its sovereign debt, it has used inflation many times, starting just after the Revolutionary War and most recently after the Vietnam War, to devalue its mountain of debt. At 3.5 percent, the doubling rate of money is 20 years, which is to say the outstanding debt of the U.S. government is cut in half every 20 years with 3.5 percent inflation. At 7 percent, money doubles every 10 years and thus U.S. government debt is halved each decade. Governments that have a mountain of debt, like the United States, benefit greatly from inflation. Expecting our government to be genuinely serious about keeping inflation low is like expecting fraternity brothers to give up beer and mixers with coeds. Ain’t gonna happen as long as global bond buyers continue to buy our debt, which in turn helps finance our deficit spending and consumption of imported goods.
Consumers viscerally understand inflation as the cost of groceries, heating oil and other staples increasing faster than their wages. However, this type of inflation is driven by increased demand from the world population for raw materials and basic resources, not by government printing presses. Consumer commodity inflation reduces disposable income and has a deflationary effect on discretionary purchases. Household budgets cannot purchase as much and families must cut back on their luxury purchases like eating out, premium movie channels and personal hygiene. Commodity inflation impacts real estate operators to the extent that they purchase materials for their property management needs. But generally, that does not materially impact net operating income.
Another variation of the inflation snowflake is contractual inflation. Contractual inflation is created by provisions in union and government employee contracts that increase wages and/or pension benefits in step with an increasing Consumer Price Index. This upward pressure on wages does not cause inflation but given the sheer number of government employees, once inflation starts, contractual inflation adds fuel to the fire. Most importantly, the CPI is used to index Social Security benefits to keep payments in pace with inflation.
But just as we need multiple terms to define inflation, we need multiple words to describe the CPI. Starting in the early 1980s, the definition used by the Bureau of Labor Statistics to calculate the CPI began to change. Under both the Clinton and Bush administrations, this tinkering continued in earnest. Today the measure incorporates the concept of core inflation, which removes the costs of food and fuel from the index. That is no problem, provided we can figure out how to live without food and fuel, of course. Believing the reports issued by the Bureau of Labor Statistics as gospel without digging under the surface will lead to significantly understating true inflation, which in turn can have a drastic impact on inflation-adjusted yields. The motivation for this political tinkering is simple. If the CPI records modest inflation, then the increase in cost to the U.S. government for Social Security entitlements and government-employee wages and pensions is significantly lessened.
Understating true inflation also wreaks havoc on macroeconomic models that calculate the size of the deficit and our national debt in comparison to our gross domestic product. GDP is reported without adjusting for inflation. A lower reported deficit and debt compared to an unadjusted GDP makes our fiscal policies look better than they really are. Additionally, a lower CPI provides the Federal Reserve with the authority (and political cover) to keep interest rates low and still adhere to its mandate of fighting inflation. Never mind that the measure of inflation has been changing to suit political agendas, as long as buyers of treasury notes believe that inflation is low, all is well.
But is it? Self delusion is not conducive to making informed investment decisions. If a real estate investor doesn’t know the true rate of inflation, he or she can't accurately forecast budgets for properties considered for acquisition. If investors use an inaccurate CPI in lease provisions, rents may not keep up with true inflation as intended. If bankers suddenly discover that inflation is running higher than they had forecasted, they will quickly offer only adjustable-rate mortgages, which eliminates an investor’s ability to use inflation to help repay debt. Using an inaccurate CPI lures investors and bankers alike to drive into an inflation blizzard using a dashboard with a broken dial.
If monetary inflation is the dragon investors fear, then logically having an accurate gauge to measure when it might arrive seems a crucial early warning system. If the needle is glued to forever point at a constant 3 percent inflation rate, then surely we will be surprised when the inflation dragon rears its head and we scramble for our swords and fire extinguishers. All of which leads me to wonder: What is the Eskimo word for government snow job?
Practitioners of residential and commercial real estate don’t generally cross pollinate, but in this instance one fix does apply to all. A simple way for both homeowners and investors to protect against inflation, whatever its rate, is to secure a fully amortizing loan. Predicting when inflation will commence and how high it will go is difficult. This strategy is indifferent to timing and the rate.
Moreover, with a fully amortizing loan you, and I, can fantasize about pushing a wheelbarrow overflowing with inflated currency (like citizens of Zimbabwe and Weimar Germany did to pay for groceries) into my lender’s offices to pay off both my home mortgage and my apartment loan with the equivalent of a steak dinner. This result would be terrible for our economy, but I grin with expectancy nonetheless.
