The Tunnel at the End of the Light?

Inflation might increase at a rapid trajectory, sinking much of what was gained in the past six months.

There’s an old Chinese proverb that I like: “If we don’t change direction, we’re going to end up where we’re headed.” It reminds me of the current state of commercial real estate finance and how it will inevitably affect the apartment industry. So far, including the last part of 2010, we’re heading into a low cycle, one characterized by gradually improving business conditions, growth in general employment and some settling in the investment markets. I’ve been saying for years that this recession, despite the oddly shaped dip you see on graphs in the paper, has really been a leaking trough. It helps to explain why it has taken so long for the demand to back-fill that annoying drip that caused concessions to grow.

The improvement in rental conditions has been nothing short of amazing, and certainly within the context of this time in the cycle, it has been a continual bright spot. Multifamily is related to and not alone in the newly cast bright light of renewed demand. Both office and retail have shown some improvement as well. The increase in office leasing, especially in major markets, signifies a welcome willingness to take up more space and hire professional staff. Between those gaining ground with promotions and the new hires, the apartment industry will get its share. On the retail side of commercial real estate, retail sales are up as much as 4.5 percent in some places, and while spending is anticipated to wane on a seasonally adjusted basis, consumers are venturing out more and demonstrating a comfort level with their situation and personal finances.

If business spending picks up, then the prospective torrent of new hires, especially among recent graduates still seeking a position, will provide very bright headlines.

With all of this good news, and the velocity with which things have turned around, I am concerned about all points heading to the same destination. Let me explain. If the economy gains steam, and the rate of rent gain maintains its present course, then the two components of the CPI–however reviled by economists–will needlessly drive inflation and cause the “tunnel” effect. One where prices, rental rates and inflation, and interest rates try to stay at the same rate. Inevitably inflation jumps the track and makes it out of the tunnel before the rest.

How realistic is this? Rents are growing and are reflected in both privately released data series (think Pierce-Eislen) and the Bureau of Labor statistics CPI series for core inflation. It represents, depending on how picky you get, about a third of the CPI gain or loss, recognized for the owner’s equivalent rent and rent of a primary residence. I don’t want to confound this by the absolutely inane way they do the calculation (okay, but maybe a little).

The most recent releases by economists I really respect and follow all seem to agree that inflation, at a pet-rock pace of less than 1 percent right now, might increase at a rapid trajectory, sinking much of what was gained in the past six months. If we get rental inflation at the same time that we get inflation targeting by the Federal Reserve, it will have successfully killed off the demand wave we are now enjoying. And that risk is completely out of the press right now. With nominal interest rates forecast to begin climbing by midyear, that tunnel is looking all the more crowded with every passing day. For once, I’m going to look away from the light.

Jack Kern is the managing director of Kern Investment Research, LLC and the current chair of the Association of Real Estate Research Professionals. Jack recently returned from a fact finding trip to Hawaii and discovered it is much less expensive to buy pineapples and coconuts locally at the Safeway rather than smuggle them in a bowling ball case. He can be reached at or by calling 301.601.1900.