Deflation’s Effects on Commercial Real Estate

“A thing lengthy expected takes the form of the unexpected when at last it comes.”- Mark Twain. Hardly a day goes by when I don’t pick up a paper or watch the news and hear another journalist or economic prognosticator ratcheting on about the looming threat of inflation. I half expect to see men and women lined up outside the local House Depot, clamoring for their wheelbarrows to carry their unwanted money to the bank, much like the days of the Weimar Republic in Germany in the 1920s.

But as we are reminded by Mark Twain, the expected does not often happen. So let me offer a doable option in the form of inflation’s ugly cousin – deflation – and how that may possibly impact commercial actual estate in the not-so-distant future.

As those who followed the late economist Milton Friedman will attest, inflation is and constantly will be a monetary phenomenon: Too much funds chasing too couple of goods, causing a general rise in the level of costs of goods and services.

The key word here is chasing. In actual estate this means higher cost for material and labor which translates into greater building expenses and ultimately greater rents. To combat inflation, central banks fight back with higher interest rates equating to higher borrowing cost to builders and owners.

The most frequent trigger of inflation is the soaring deficit our government is running and the resulting massive expansion of the cash supply. Under regular times this surely would sound the inflation alarm, but in a period of de-leveraging like the 1 we are in right now, the velocity of money is much more important than the quantity of income. Too significantly money is just too significantly funds when it is not moving by way of the method.

Contemplate the Japanese economy, where the mounting debt is equal to 170 percent of GDP, the largest amongst developed nations and almost twice that of the United States. They have been battling deflation for decades with interest rates near zero. Their stimulus efforts went to prop up “zombie banks” and did not allow the marketplace to establish a clearing price for the collateralized assets. The net effect has been a prolonged period of reduced demand and lower prices for most assets – including actual estate.

Back in the States, where our stimulus is not getting outside the banks to permit for new loans that fuel demand, it is unlikely that the velocity of domestic funds will improve anytime soon.

Changed spending habits fuel deflation

Take into account the present U.S. economy where consumer spending accounts for practically two-thirds of our economic output. With actual wages in decline, excess capacity in the labor market, a contraction of accessible credit to consumers and a prospective secular shift in spending habits amongst consumers – the savings rate for U.S. households has risen from absolutely nothing to far more than five percent of income in a brief period of time – it is doubtful that we will be able to rely on the Jones’ consumption patterns to stoke the economic engine sufficiently to create inflation. When a cyclical recovery does occur, it is likely to be sluggish for really some time.

This leads us to one more assumption that foreign borrowers will no longer be willing to finance our deficits and will begin to diversify their foreign exchange reserves driving down the value of the dollar making greater costs in commodities (most commodities are priced in US dollars) and other goods. The largest foreign holder of US Treasuries is China, where the economy is heavily dependent on exports to the US (less than 8% of the Chinese population has any discretionary income). It is improbable to assume that the Central Bank of China will not continue to support its own economy by continuing to obtain US dollars and therefore make their goods much more inexpensive to the US shopper.

So just before we slip into a boring narrative on macro economics lets bring this back to the topic on hand and how deflation, rather than inflation, could be the peril we will need to be watchful of and how that will have an effect on commercial actual estate in the near future. How will that impact commercial actual estate in the near future? We have already seen a general decline in rents across all commercial property kinds by as much as 50 percent in some sectors. The price of creating continues to decline, despite the fact that at a much a lot more subdued rate, but with out accessible credit, it is improbable that there will be sufficient demand to spur new development. Though the economy is stabilizing, there is unlikely to be a sustainable force of consumption to preserve historical growth rates.

With adversity comes opportunity. Investors who have over-leveraged will discover that risk does not pay during deflationary periods and cash becomes king. Opportunities will continue to arise as the calamity unravels and a new generation of capital flows into the marketplace. This, of course, will take years to play out and very good sound counsel will once more be at a premium.

Mike Eyer is an advisor with Sperry Van Ness / The Group Commercial in Fort Collins, CO. He can be reached at mike.eyer@svn.com or follow his blog at http://mikeeyer.blogspot.com