Since 1971, when the United States went off of the gold standard, inflation has become a much bigger concern within our economy. Huge amounts of money have been added into the economy since then, causing rates of inflation that have been unprecedented within our country’s history.
When it comes to the value of commercial properties, inflation will cause these values to rise over time. When more money is being added into the economy, and that money then begins circulating, people now have more money that they can spend. If the supply of commercial properties in an area remains relatively the same, people will be willing to pay more money for these properties because they now have more money to invest. This in turn can then drive cap rates down, at least in the short term. But over the long term, rents will then rise due to inflation, and the cost-of-living adjustments within leases will then help the overall lease rates to adjust to their current fair market values.
But what then happens when the Consumer Price Index, which has become the basis for rental adjustments within so many leases, no longer remains a good measure of inflation? In recent years landlords have scratched their heads, noticing big increases in the prices of food, gasoline, and energy, and wondering why the Consumer Price Index hasn’t reflected this.
Under ideal circumstances, many of us would want to see the Consumer Price Index reflect true changes in the cost of living, on an “apples-to-apples” basis from one time period to another one. But this hasn’t really been the case, as the weighted components utilized to measure the index have been changing over time. Information reported on the Web site ShadowStats.com, for example, shows us that if the Consumer Price Index were calculated today the exact same way that it was back in 1980, today’s reported inflation rate would be much closer to 9% when compared to the 1½% inflation rate that’s being reported to us.
When the housing market was on fire, and home prices were rising dramatically in many areas, the weighting for the price of housing within the index was reduced. Correspondingly, when housing prices began falling dramatically in many areas, the weighting for the price of housing within the index was then increased.
In terms of the price of energy, in which we’ve seen dramatic increases over the past twelve years or so, less weighting has now been given to the price of energy within the index.
So what we have then is not an “apples-to-apples” index that measures true changes in the inflation rate over time, but rather an index that tends to indicate that we have low inflation. This then holds cost-of-living adjustments in commercial real estate leases down, and it also helps to hold interest rates down…because lenders want to receive higher interest rates when inflation is higher. These lower interest rates in turn help to support and increase property values, as buyers will pay more money for properties when their monthly payments are going to be lower.
Inflation has a solid impact on property values, rent values, and on the cost-of-living adjustments within your leases. Knowing and understanding this along with the underlying methods now being utilized to calculate inflation rates, will help you to understand our economy even better.