How Unemployment and Inflation Could Affect Commercial Real Estate Values

The most common question I am asked these days is, “When will the good times return to the commercial real estate market?” That question is impossible to answer with accuracy as we are in unprecedented times with unprecedented government intervention and an unprecedented global recession. Below is a scenario that I think could be possible and may even be probable based upon what we are presently seeing in the market.

I have read many reports recently stating that “experts” are seeing a turnaround in several segments of both the commercial and residential real estate markets. Intuitively, it is difficult to put any credence in these reports due to one very important fact. There is no other metric that is more closely tied to the fundamentals of real estate than employment and there is no indication that we are close to seeing a peak in unemployment. We are presently at a rate of 9.4% nationally and economists’ estimates have risen from a peak of 9%-10% to as much as 11% before the trend reverses. The implication for real estate value is acute.

As unemployment rises, people who have either lost their job or fear losing their job do not move to a larger rental apartment and do not move from a rental unit to purchase a residence whether it is a single family home, co-operative apartment or a condominium. As unemployment rises, companies do not increase their need for office space and may shed excess space adding to the vacancy and availability rates. It is easy to see how the fundamentals of real estate are most stressed when unemployment reaches its peak.

The most optimistic economists predict that the economy will begin to turn during the third quarter of 2009 (the most pessimistic see the turnaround sometime during the first half of 2010). Unfortunately for the real estate market, unemployment is a lagging indicator and it is likely that unemployment will peak three to six months after the economy turns. That would place the peak at the end of 2009 or the beginning of 2010 in the best case scenario.  This is the point at which the fundamentals of our market will be suffering the most and this is the point at which value will hit a bottom.

The question then becomes, when will value start to climb? In order to answer that, we must consider the potential impact of inflation. Will we have above trend inflation? It is hard to imagine that inflation will not be well above trend as the amount of government spending we have seen, coupled with the overtime the printing presses at the Treasury have been putting in, is creating a very likely potential for excessive inflation.

If this inflation kicks in, what are the ramifications for real estate values? There are two impacts, one positive and one negative.  In an inflationary environment, a flight to hard assets is prudent as cash in the bank loses purchasing power each day. Commercial real estate is a great hard asset to own so demand for the asset class should increase. But with inflation comes intervention from the Fed in the form of increasing interest rates. The Fed’s comfort zone on inflation has been in the 1%-2% range on an annual basis so anything over this range will prompt the Fed to tighten monetary policy ie, raise interest rates. Currently in the 6% range, mortgage rates could climb to 8%-9%

If interest rates rise, mortgage rates will rise. Given economic conditions, we are likely to see an extended period of positive leverage again as we did throughout most of the 1990s after the S&L crisis of the early 1990s left lenders underwriting in a very disciplined manner for the balance of the decade as the “sting” of the crisis was still fresh in their memories. If we see positive leverage, we could see cap rates rise into the high single digits to low double digits range. This dynamic will have a negative impact on real estate values.

Rising interest rates will be only one of a two part wallop to the market. The other is the impact of a deleveraging process which will play out over a multiyear period as it is based as much on mortgage maturity as a deterioration in fundamentals.

After value hits its low point, it is likley that value will simply bounce along this bottom for a period of years as the dynamics mentioned above play out and distressed sellers consistently add to the available supply of properties for sale.  It might be 2012 or 2013 before any meaningful appreication is seen in the market. If this happens, why should an investor buy now not waiting for value to clearly hit a bottom? There is a good reason.

Calling an absolute bottom of a cycle is nearly impossible and if you want to buy a hard asset as an inflation hedge, you want to buy that asset at a time before interest rates start to meaningfully rise. Buying an investment property today will give the investor the ability to lock in fixed rate financing at today’s low rates. The asset will have steady debt service payments while inflation increases rents and the value of the asset over time.

This is only one of a number of scenarios that might play out in the coming years. No one knows for sure what will happen but if I was a betting man, my bet would be on the analysis presented above.

19 Responses to “How Unemployment and Inflation Could Affect Commercial Real Estate Values”

  1. 1 Mr. Bippy - Atlantic City June 22, 2009 at 8:47 am

    Aren’t there other variables that play into the interest rate level that could allow interest rates to not only hold if the Fed Fund Rate raises but couldn’t they could actually drop? I believe we had a lower mortgage interest rate environment during the 05 – 07 years while the Fed Fund Rate was higher than it is today. Do you think it would be plausible that mortgage interest rates could drop while a raising of the Fed Rate? With an initiative of a public private plan such as the P.P.I.P sponsored by Geitner and bond companies like PIMCO which could create the secondary market for mortgage backed securities thus loosening the choke hold on institutional investors ability to lend. This is likely to create a more competitive lending environment which would force banks to narrow their already historically huge spreads thus placing downward pressure on interest rates. Thoughts?

  2. 2 rknakal June 22, 2009 at 9:04 am

    Hi Mr. Bippy, Thanks for your post. You make a good point here about spreads that banks are realizing. Mortgage rates have remained fairly constant as the Federal Funds Rate has gone from 4% to near zero. Banks have become used to this spread and this dynamic is helping to recapitalize the banking industry. With regard to commercial real estate, the shadow banking sector (Investment banks and hedge funds via CMBS and other vehicles) contributed a substantial percentage of commercial financing and has evaporated and until that sector comes back the competition among lenders will not get to the point that spreads will be greatly compressed. The traditional banking sector is not large enough to satisfy the existing demand for financing. With regard to the PPIP, time will tell how successful that program will be. As I have stated several times, there are tremendous profits to be made by the private sector through this program but who will actually want to partner with the government?

  3. 3 Gabriella June 22, 2009 at 12:03 pm

    About inflation: I don’t think we will see any infaltion in the short to medium term because the additional liquidity has been directed to pay off debt and shore up the failure of the entire fiancial system. Consumers’ demand for goods and services is decreasing; without the stimulus of additional consumers’ demand I have trouble seeing an inflationary scenario. As far as real estate is concerned, I think there are opportunities out there provided one has the staying-in-power and the patience to ride these difficult times.

  4. 4 rknakal June 22, 2009 at 12:22 pm

    Hi Gabriella, Thank you for your post. I don’t think we will see significant inflation in the short run either although we have seen noticable increases in commodity prices and oil prices recently. Inflation is not only stimulated by consumer demand but by the value of our dollar. The dollar has shown surprising strength but with the massive increase in the money supply, the question is how long will the dollar’s strength last? It would appear to be counterintuitive to think inflation won’t set in at some point.

  5. 5 CountTheCost June 22, 2009 at 5:44 pm

    Propping up bad debt has never been a good idea, just look at the history of Germany and the Weimar Republic: the printing of money to pay for WWI reparations led to the devaluation of their currency the German Mark, then led to inflation, then printing more money, then hyperinflation. Assets need to be revalued downward, now, including real estate, unfortunately. There are no new laws to the economy. The New Economy was a lovely fairy tale: living on borrowed money and on borrowed time. The housing bubble made everyone feel rich, but the home equity borrowing by consumers was an illusion encouraged by all parties. Securing debt and repackaging debt is no way to run a nation.

  6. 6 rknakal June 22, 2009 at 6:24 pm

    Hi Count, Thanks for your post. I agree with your position and remain concerned that cheap money will be replaced with even cheaper money, leading to inflation and all of the remification mentioned in my post. Inherent value must adjust.

  7. 7 ccummings June 23, 2009 at 5:31 pm

    Hi Robert –

    Thanks for your column. I’ve been trying to explain to my friends how this current “crisis” came about and the huge pitfalls associated with how the gov’t is choosing to handle the crisis. In my opinion, it’s a short-term delay of long-term pain. Values do need to adjust, inflation is going to be an issue – and probably right as the market starts to turn, tax increases are going to suppress employment and expansion, and securitization in some form or fashion is going to re-emerge. I also think this current market is going to have long-term implications for the financial sector – both in terms of overall structure, and in employment opportunities. I think we will see a re-balancing of jobs, a glut of failed retail establishments (we were/are so overbuilt in terms of retail – partially driven by overblown consumer spending that was created by artificial wealth), a flattening out of residential real estate prices across vast markets, and a continually shrinking and interdependent world. It’s also hard for me to imagine how we continue to maintain our status as “top dog”, or if we even still maintain it now. We certainly have a lot of work to do – and growing our government and over-taxing future generations is not going to get us there. It never has and it never will.

    On a side note, wanted to elaborate on my securitization comment above. It really was a very useful tool as initially designed and used. The most recent iteration was, unfortunately, nothing like the original – rather it was merely a “shell” of it’s original incarnation (pun intended). It created artificial lending capacity and artificial wealth on so many levels. However, the ability to take first generation, or direct asset-supported debt off of a lender’s balance sheet through securitization was absolutely brilliant. Third and fourth generation securitized obligations that were so far removed from the original, underlying assets, but that were still highly rated, and still being bought – albeit by people who had no idea what they were buying (outside of a rating), were doomed to fail.


  8. 8 David Herzog June 23, 2009 at 5:47 pm

    It seems that there will be an order of events that embrace a future recovery.
    1.) Absorption starts to take place, as you say it will trail employment gains by at least 6 months.
    2.) Developers get back in the game. This will trail improved absorption rates by about another 6 months.
    3.) Developers deliver new space at significantly higher cost/sf; this will trail #2 above by 2 years.
    4.) Rents per SF on existing properties will move up in response to #3 above.

    It can be a roller coaster, enjoy the ride!

  9. 9 Carl Todd June 25, 2009 at 9:24 am

    In 1929 90% of the consumer goods were made in USA. We were a nation rich in raw materials to fuel or industries. On that point Japan went to war with us (WWII) because we refused to sell them petroleum.

    Henry Ford started the industrial middle class by paying his workers a higher enough salary ($5/hr.) to be able to purchase a Ford car.

    Today our economy is reported to be 70% dependent upon the US consumer. 90% of the US jobs are in the service industry that is rapidly going out of the Nation via the Internet. Office buildings house the service industry. Even there technology has changed the need for space per employee. Not to long ago the ratio was 400 sq.ft. per employee. Today it is less than 100 sq.ft.

    Until we started producing consumer goods here in factories that are using the latest hi-tech production machines that we are exporting to nations in the second world that are manufacturing the consumer goods that fuel our consumer based economy this recession/depression will not end. A worker who lost a middle income wage paying job how is either working part time or for minimum wage can not fuel a recovery. Remember the unemployment rate does not include people no longer collecting unemployment benefits and/or who want to work but can not find a job and are now too discourage to continue looking for one. Neither can the older displaced office worker do infrastructure heavy labor work at their stage in life.

    We need a major restructuring of our industrial/service base and until this done low interests rates only penalize the retirees that in the past has fueled many facits of the consumer industries and if the banks don’t finance the maturing commercial mortgages we are no wheres near the end of this down-turn.

  10. 10 rknakal June 25, 2009 at 7:00 pm

    Hi Carl, thanks for your post. You make some interesting points. I think the average square footage per employee is probably more like 200 to 250 per employee. At any rate, thanks for the thought provoking post.

  11. 11 Carl Todd June 26, 2009 at 6:55 pm

    It would be a valuable analysis asset to see a study of the square foot of office area per employee in the various office building users such as professions, service industries,software development, etc. That would give us a handle on the future absorption rate of the current supply of vacant office space and the demand for the future needs with regard to the types of and locations of buildings that the various users prefer.

    In Manhattan I can evision 1st. Ave between NYU Med. School and the Sloan-Kettering complex becoming an R&D bio-tech corridor. All it would take is a balanced re-zoning to encourage the buildings to house the industries and financial incentives as was done for down town for bio-tech firms to locate there.

  12. 12 rknakal June 28, 2009 at 1:02 pm

    Hi Carl, thanks for your post. It would indeed be interesting to see a study of those square footage amounts broken down by industry. To my knowledge, no one tracks that data. I agree with your rezoning suggestion. Planning can do wonderful and transformative things to a city. Amanda Burden and City Planning have done a great job of thinking on a macro basis and then implememting directives that make both economic and quality of life sense for NY.

  13. 13 Carl Todd June 28, 2009 at 7:02 pm

    In the late 1960’s the REB of NY asked Frank Whitman (Farber- Whitman firm) to do a study defining office building GLA. Frank was an officer in The American Society of Appraisers I was a Senior memberof ASA employed as a Senior Appraiser in NYC-DRE involved with determining office rental values for City agencies. I was also a member of the RE board at the time. Frank asked me to be on his committee and we and others whose names slip my memory did an extensive study that the RE Board and BOMA both adopted to determine office bld. GLA.

    It would be time again to ask the RE Board to form a committee to do this study as the commercial brokers active in commercial leasing are at the fountain head of the types and areas commercial tenants demand, settle for and utilize. It would be invaluable to not only the appraisers but the brokers too.

    The study could be extended Nationally through the National Board and it would be interesting to see if there is a Regional and City variation for each class of user.

    The big question is “How do you get it started?”

  14. 14 rknakal June 29, 2009 at 11:53 am

    Hi Carl, thanks for the post. I understand your perspective and think it would benefit the industry to have a common measuring stick. That would, however, be met with opposition from some who feel it is advantageous to operate without the transparency that it would provide. It is a great thought though.

  15. 15 payday loan lenders June 30, 2009 at 12:23 am

    I found very informative. The article is professionally written and I feel like the author knows the subject very well. keep it that way.

  16. 16 rknakal July 1, 2009 at 9:36 am

    Hi Payday, thanks for the post.

  17. 17 Harry September 2, 2009 at 3:05 pm

    I don’t think positive leverage results from inflation. In the 1990’s we had severe negative or reverse leverage where interest rates far exceeded cap rates. The more borrowed the lower the cash on cash returns. As I understand it, positive leverage is where the returns grow as the investor borrows more. In theory, you could have a 6% cap rate and borrow 100% of the cost at 5% and clear the difference of 1% with zero cash down. I understand this to be positive leverage, but perhaps I am missing your point.

  18. 18 rknakal September 2, 2009 at 7:17 pm

    Hi Harry, thanks for your post. Inflation does not have anything to do with negative or positive leverage. My point was that after a period of crisis, like the S & L crisis, underwriting becomes more conservative by banks and by investors as the difficulties of the down market are still fresh in everyone’s mind. Emerging from this crisis should be no different. Throughout most of the 1990’s, we saw positive leverage (cap rates were higher than lending rates) as evidenced in the 25 year New York City multifamily property study that I completed recently. We compared cap rates and gross rent multipliers (a method of valuation frequently used in New York) to lending rates and the 10 year t-bill from 1984 through 2009. The stats are quite interesting. I have your email address and will be happy to email the study to you. If anyone else would like a copy of the report, please feel free to email me at

  19. 19 German real estate - properties24 August 10, 2010 at 9:27 am

    Thank you for the interesting article.

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