It’s been difficult to focus over the past few months with all that’s going on in the world. One of the big concerns for those of us in real estate is how assets will perform in the future given the significant turmoil we have in the economy and the resulting monetary actions. I’ve had a lot of conversations with very smart people over the past five months about the possible outcomes we’ll see. Everyone has very strong convictions about what could happen under different scenarios, but nobody had any idea which of those scenarios will actually play out. In March and April, the big question was how quickly COVID-19 was brought under control. If the pandemic ended quickly, as we all hoped it would, the economy should bounce back rather quickly and the real estate market would be ok. If it turned out to be a protracted pandemic with the economy shut down for an extended period of time, then it would be a much longer and harder road to recovery for the economy.
We now have the answer. COVID-19 has not gone away quickly and will likely be something we’re dealing with for quite a while. The conversations are now not about whether real estate will be affected by the consequences of a prolonged pandemic, but how and to what extent. We’ve seen the dramatic shift to working from home and are uncertain of the implications for office and retail demand if the shift becomes more permanent. We’ve seen many small businesses shut down that probably won’t return. We’ve seen massive stimulus pumped into the economy (more US dollars were printed in June than the first two hundred years of the existence of the United States). And in a just few months, we’ll have an election in which the outcome could result in dramatically different economic policies.
So I’ll spare the suspense of waiting until the conclusion to say that still nobody (that I’ve spoken with) really has any idea of how things will play out over the next few months and years. One thing that could have a major impact on the performance and value of real estate over the next decade, however, is inflation caused by the massive monetary and fiscal responses of governments all over the world.
Most economists believe that there won’t be much in the way of consumer price inflation, but that we could see significant asset price inflation. Consumer prices consist of everyday goods at services that people buy and consume, such as groceries and gasoline. Asset price inflation, on the other hand, refers to the price of assets such as stocks, bonds, and real estate. This article will focus solely on the impact of asset price inflation.
There is some precedent for this belief in future asset price inflation. The 2008 financial crisis has been used as a study for how economic stimulus packages impact the economy and asset prices. But this crisis is different and there are other factors at play now that make it far less certain if we’ll see the same patterns following the COVID-19 related recession and stimulus.
A Closer Look at Inflation Prospects
The main argument for the prospect of high inflation is due to the monetary and fiscal policies of governments around the world in response to COVID-19. According to McKinsey & Company, global stimulus packages had surpassed $10 trillion as of June 2020 and far surpass stimulus packages during the 2008 financial recession as a percentage of GDP, seen in the chart below, with additional stimulus packages proposed in the United States.
A thorough description of how stimulus funds affect asset prices is a much larger discussion, but to explain it simplistically, when additional money is pumped into the economy and interest rates are cut to artificially low levels it becomes much cheaper to borrow. This naturally increases the demand for borrowed funds in order to purchase assets. Once the economy stabilizes, there will be an excess of funds that need to be absorbed, leading to higher asset prices. We saw this effect after the 2008 recession, resulting in one of the longest and biggest bull markets in history for stocks and real estate.
Most economists don’t believe there will be much consumer price inflation or asset inflation in the short-term, but many do expect significant asset inflation in the coming years as the economy begins to recover from the pandemic shutdowns, similar to the years after the 2008 recession. The question that many people are asking, however, is whether or not this time is different. Fears exist that major cities such as New York will face a permanent shift in the demand for both office space and retail space. States are experiencing major shortfalls in income and are expected to face a cumulative $555 billion budgetary shortfall over the next few years. Cities and local governments will see additional shortfalls in the coming years, magnified by the growing costs of addressing the pandemic. And the outcome of the election in November will likely mean significantly different tax and social policies that will directly affect real estate investors.
Real estate has long been a hedge against inflation. If inflation is high and reduces the spending power of a dollar, that same inflation usually leads to increases in prices and rents. So inflation itself isn’t necessarily a bad thing. The problem is the uncertainty as to whether or not investors should price in inflation to their value estimates. The hesitation to believe that inflation will definitely be present mostly centers around the chance that demand simply may not return to the same level it was before the pandemic, a deflationary pressure, competing against a massive amount of new money pumped into the economy, an inflationary pressure. The working/buying/eating remote trend may continue, putting downward pressure on the demand for and value of commercial properties while an increase in the supply of money could increase the demand for funds and assets, driving prices up.
The other major argument I’ve been hearing is that this recession is different than other recent financial crises because of the tremendously negative impact primarily borne by the low-wage service sector of the economy. During the 2008 recession, most restaurants, bars, and stores were still open, albeit with fewer employees and customers. But this time most of these businesses were completely shut down, meaning no income to employees or small businesses, and many are unlikely to ever open again. Getting new businesses up and running to employ this sector again will be a long and expensive process. To put it in perspective, from March 2020 through July 24, 2020, 49 million people had applied for unemployment insurance, compared to just 8.3 million people from December 2007 to December 2009. The depth and breadth of this recession is significantly more intense than it was in 2008-2009.
We’re facing an unparalleled combination of factors that put intense inflationary and deflationary pressures on the economy at the same time. While short-term effects are easier to predict, longer-term impacts are much more difficult, especially given the divergence in indicators and the prospect of both high long-term unemployment and additional stimulus, exacerbating the two forces.
The announcement on Thursday by the Federal Reserve to deviate from their long-standing two percent inflation target is a good indication of an expectation of higher inflation in the future. Given the stagnant economy and need to boost the labor market, this change seems to put less emphasis on the future impact of additional money in circulation than it does on strengthening employment. Following the change in policy, the Fed released the following statement: “The Committee seeks to achieve inflation that averages 2% over time and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
This combination of potential long-term low rates and a higher tolerance for inflation will force real estate investment firms and lenders to review their strategies going forward. The impact of inexpensive borrowing and the expectation of prolonged higher growth rates following an economic rebound could change valuation assumptions.
There is much to think about when it comes to what the world will look like in the future, much less the real estate market, in both the short-term and long-term. We’ve all made drastic changes to our lifestyles over the past six months and we wonder how much those changes will remain permanent. We wonder if businesses will survive or return. We wonder if cities will be the same or if people will begin migrating to less dense areas. And we wonder how inflation could impact our investments and our livelihoods. I don’t know the answers to these, but it will certainly be interesting to see how it all plays out.