With the current inflation environment, is it time to refinance or sell?
The money supply is one of the primary tools used to measure market liquidity and right now it’s at an all-time high. One of the main drivers behind this increase is the monetary policy the Federal Reserve enacted to combat the widespread pandemic-caused disruption. It’s interesting to note there isn’t anything structurally wrong with the economy. Rather, the majority of the business interruption was caused by government-led or behavioral closures that for the most part turned out to be temporary. This massive increase in money supply has led to both transitory and permanent inflation. Let’s look at the causes and effects of these two types of inflation and what they mean for commercial real estate owners.
TRANSITORY VS. PERMANENT INFLATION
Many economists and other experts believe the rising, more temporary, transitory inflation, is caused by the supply chain breakdown during the widespread shutdown. They expect the pent-up demand and lack of supply will self-correct during the next few quarters. Permanent inflation, on the other hand, is structural inflation triggered by additional liquidity flowing into a system where there are no real changes in supply or demand. We’ve witnessed this slowdown in new supply in many industries, including commercial real estate. This environment has the potential to create a perfect scenario where we will see permanent rent and price increases across multiple industries, particularly in commercial real estate. Asset classes and sectors that have the ability to adjust rents quickly to meet changing conditions, including hospitality and multifamily, are likely to perform well.
In addition to the massive increase in money supply, the Fed has adopted a strict policy to keep interest rates low, hoping to use this strategy to moderate inflation, which it feels will ensure a healthy economy. Adding to this accommodative monetary stance, the government’s aggressive fiscal spending policy sets us up for a classic asset inflation scenario. When there is asset inflation, real estate asset prices increase in value, even without corresponding consumer price inflation. In this situation, while rents may rise by 20%, property values may actually jump by 40%. Or as another example, the price of a gallon of milk might go up by 10% yet the value of the factory that produces that gallon of milk increases by 20%. This additional increase in the asset prices is largely caused by the availability of cheap leverage and the need for investors to put liquidity to work. The best way to play the inflation game, therefore, is to maintain or even increase exposure to commercial real estate while prudently using leverage and properly managing interest rate, recourse, and operational risk.
RISING INFLATION + LOW INTEREST RATES
As inflation takes root in the average American’s life, taking advantage of the combination of asset price inflation and low interest rates can position hotel and other commercial real estate owners’ portfolios for success. One of the many ways to take advantage of this is to refinance or recapitalize owned assets and lock in long-term low interest rates wherever and whenever possible.
REFINANCE OR SELL
Another way to benefit from asset inflation is to sell. Before putting a property on the market, however, consider the tax consequences in an increasing tax environment, as well as the pressure to replace the gains in a 1031 exchange (while available) or put the cash to work in an inflating environment. As classic economic principals suggest, being in cash in an inflationary environment could stunt portfolio growth. Conversely, using leverage essentially creates a negative cash position, which could be rewarding if executed with proper caution. Yes, putting a long-term life insurance company loan or a CMBS loan definitely comes with caveats, because of course there are no free lunches. However, when all is said and done, a properly capitalized asset with prudent leverage and maximized tax benefits is the most efficient way to own and grow commercial real estate portfolios.