What the Latest Inflation Trends Mean for Real Estate Investors
Why Housing Data Lags Will Dictate a Fed Pivot and What This Means for Commercial Real Estate
The surge in inflation has been in the headlines for a few years now. While Consumer Price Index (CPI) has primarily held the spotlight, Personal Consumption Expenditures (PCE) is the Federal Reserve’s preferred measure of inflation. A deeper understanding of both is valuable for multifamily real estate investors.
First and foremost, inflation isn’t about high prices; it’s about the rate of rising prices. A lower inflation rate does not mean prices are going down. It just means that prices are going up more slowly. Inflation isn’t inherently bad. It’s too much inflation (e.g., costs of goods and services rising too fast) that is the problem.
The Covid stimulus inflationary period is over. Supply chain shocks have been worked through, and accumulated savings have been spent. It may not feel like it right now, but underlying data tells us the story.
When you break down the components of CPI and PCE, especially housing costs, and understand how lagged some of the major components are, it’s obvious that the Fed has done its job and it’s time to cut interest rates.
Before we get into the details, here’s a question to ask yourself…If the Fed is about to change course from holding interest rates at 5.25% to 5.5% (effectively 5.33% as of 7/17/24) to cutting rates later in 2024 and all of 2025, what does this mean for your investment strategy?
Here’s our perspective:
- We will see increased liquidity and transaction activity. Liquidity is reintroduced into the system, and transaction activity increases as investors gain more confidence in the path of interest rates. General uncertainty around the path of rates is lessened, and more funds come off the sidelines. Valuations for all leveraged asset classes will improve in a lower-rate environment.
- We will get access to lower floating-rate and fixed-rate debt. Rate Cap costs and Rate Cap Escrow costs come down, and quickly. When this happens, almost all floating rate loans will have both lower debt service costs and lower rate cap and rate cap escrow costs. We should see more assets on the market with appropriate pricing for the seller but still below market peak and below replacement costs.
Let’s take a look at the details…
CPI and PCE Components
Both CPI and PCE measure the rate of change in different “baskets” of goods and services over time, providing policymakers and the public with a sense of the broader financial climate. They’re measured using time-series comparisons (e.g., year over year, 6-month, quarterly, and monthly). Both are measures of inflation, but they differ in scope, calculation methods, and weighting. Note that the housing component weighting in CPI is roughly twice that of PCE.
Understanding CPI
The most well-known measure of inflation, CPI, evaluates the average change in prices paid by consumers for a standard basket of goods and services. The headline CPI can fluctuate significantly as it includes volatile components like food and energy prices. Core CPI, on the other hand, strips out these elements, providing a more stable view of inflation over time.
CPI is primarily used to make cost-of-living adjustments to things such as social security and tax brackets.
As you can see below, headline inflation (Year over Year CPI), has been coming down since the middle of 2022 – two years ago.
Also looking at the chart, you can see that starting in July of 2023, CPI’s decline stalled and basically stayed flat for a year. This isn’t “sticky” inflation.
This is because of the lagged effect and the overweight of housing costs in CPI.
CPI housing costs make up about 42% of the total index and consist of two components: Owners’ Equivalent Rent (OER) and Rent Paid by Renters. CPI doesn’t include the increase in actual housing costs. Instead, OER is the theoretical rent a homeowner would pay to rent their home from themselves. Not only is it an overestimation (since more than 70% of US homeowners hold mortgages below 3.5% and so their “rents” haven’t gone up), but these numbers lag by 12 to 18 months, whereas other inflation categories experience lags of less than 3 months.
Let’s just look at housing’s impact on CPI. Removing the shelter component (~42% weighting), you can see that YoY CPI (ex shelter, red line below) has been at the Fed’s 2% inflation target since late 2023:
Additionally, the chart below shows both the housing price index and CPI OER. If you look at where home price inflation is (in blue), it is clear that CPI OER has a long way to go down. This will drag down CPI for the rest of the year.
The inflation battle is effectively over.
Decoding PCE
The Personal Consumption Expenditures (PCE) price index is the Federal Reserve’s preferred inflation gauge. It captures the change in prices of goods and services purchased by U.S. households and is a primary input for the central bank to set its benchmark interest rate.
While similar to the CPI in many ways, the PCE has a few key differences. These include its broad coverage, comprising virtually all of the domestic personal sector, and its ability to reflect changes in consumer behavior and shifts in the mix of goods and services consumed. Additionally, housing only makes up about 22% of the basket, half the housing impact of CPI.
CPI is more volatile due to the inclusion of energy and food prices, whereas PCE tends to show lower inflation because it factors in consumer substitutions between goods as prices change, something CPI does not. This makes PCE a more comprehensive measure of inflation, with a more accurate portrayal of how individuals respond to price changes, not including the lower housing weighting.
YoY CPI
May = 3.3% (already the lowest advance since April 2021)
June = 3.0%
YoY PCE
May = 2.6%
June = Posted July 26, 2024
Source: Reuters
Like CPI, PCE is at or near the ~2.2% Fed goal. And again, once you include housing inflation’s lag and its coming impact, PCE will also come down.
How can you benefit from this information?
Regardless of the inflation metric you’re watching, it is obvious that inflation is coming down. And, if you factor in the lagging effects of housing data, it’s clear that we should be at the Fed’s stated policy target soon, if we’re not there already.
What does this mean for Commercial Real Estate investors in the next 12-18 months?
There will be increased liquidity in part due to a shift away from fixed-income/bonds and towards real estate as the days of risk-free rates of return over 5% become a thing of the past.
This increased liquidity and lowering of interest rates has historically created cap rate compression, which will improve exit opportunities and refinance opportunities for existing owners.
As we noted in a recent article about the Multifamily Kairos moment, we strongly believe that today’s market presents a unique opportunity for multifamily investors.
- Demand is still strong and forecasted to continue for years to come
- Excess supply is coming down and will be close to historic lows in the next few years
- Cap rates will start coming down
- Debt costs will come down
Being able to buy in historic opportunities like this is rare in multifamily real estate. Don’t miss your opportunity.
We look forward to reviewing your multifamily investing needs.
Schedule a call with one of our Principals to learn more.
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