Inflation Trends (% Change Year/Year, Not Seasonally Adjusted)
Core inflation, which excludes food and energy, rose by 0.9 percent in April compared with April 2009. This was the smallest year-over-year increase in 44 years and well below the Federal Reserve’s informal target of 1.5 to 2.0 percent. Inflation is low due to excess capacity in the economy resulting from the recent recession, specifically such factors as high unemployment, low factory utilization, excess housing supply and high vacancy rates in commercial properties. The slowing rate of inflation gives the Fed plenty of cover to maintain low interest rates and postpone the sale of government and agency debt that it purchased over the past 18 months to keep credit markets liquid (a strategy called quantitative easing). Low yields on cash have encouraged investors to assume more risk in search of higher returns across all asset classes. In commercial real estate, this trend is evident in investors’ willingness to compete aggressively for core properties in primary markets, driving down cap rates. Though overall inflation remains in check, global demand is pushing commodity prices higher at a faster clip, which helps explain the 5.1 percent increase in construction costs for nonresidential buildings over the past 12 months even though construction starts in the U.S. are minimal. The increase in construction costs translates into rising replacement costs, which, if the trend continues, will make existing properties look more attractive to investors. This is one reason why real estate is viewed as an inflation hedge along with the fact that landlords can raise rental rates to keep pace with inflation. Though inflation is dormant now, many investors expect it to rise as the economy recovers and private demand for credit begins to compete with government borrowing required to finance growing levels of debt.
Source: U.S. Bureau of Labor Statistics, Grubb & Ellis