If you haven't heard, Crude Oil futures are on a run-away train headed for a "Super Pike" in price chart formation. Crude Oil Futures even after adjusted for inflation are higher than they were during 1970's Oil embargo. Friday's NYMEX close for the sweet crude hit $129.07/bbl with Boone Picken's (the legenday Guru Oil Trader) predicting crude at $150/bbl before the end of the 2008. I believe just about everyone can feel the effects of higher fuel costs and how inflation is starting to spread into everything we purchase. Higher fuels, foods, metal prices are reacting to the increase costs of production due to higher energy costs. So, as investors we have to take our heads out of the Canadian Oil Sands and consider the effects of energy inflation and what that means for our investments in real estate particularly in low cap rate markets like Las Vegas, Nevada.
First, you must realize that this inflationary cycle will rhyme with those of the past, but will be very different at the same time. You can and will have deflation in some assets while inflation in others which will confuse most investors about their investment allocations. Currently, we have deflation in residential real estate but inflation in commodities like corn, wheat and gold. Both are hard assets and when you listen to comments from CNBC commentators and analyst suggesting to buy hard assets, you might think...well my real estate is a hard asset...it's an inflation hedge...so I'm fine. This is could be a deadly misinterpetation ...for the following reasons.
The Cause....Inflationary Pressures are Growing Fast!
In the June 2008 outlook written by Bill Gross of PIMCO he clearly states an important hypothesis on how the U.S. consumer price index (CPI) is understated, and how the global inflation rate for most of the world is now 7 percent and how our government has manipulated our index to the benefit of themselves and corporations on Wall Street.
(Readers FYI: Bill is being critical of the Federal Reserve and Washington's economic policies ; Emerging economies were partly to blame for America's housing and credit bubble (the Minsky Credit Cycle). As China and Gulf oil exporters purchased American Treasury bonds in order to hold down their own currencies so that they could continue to import to the USA, this demand pushed down U.S. Treasury yields and helped to fuel the housing bubble with negative real interest rates).
"But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation".
Bill's point is very clear, Bond Yields and Cap Rates are too low for the amount of inflation risks investors are taking due to the government's understatement of the headline inflation. A readjustment is about to occur in our economy and with devastating consequences...many investors will blame our government just like homeowners are blaming their lenders for their dismisses. A readjustment in inflation expectations means a readjustment in asset prices...here's another quote from Bill's June report!
"A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate".
WOW! -- a downward adjustment of 10% in commercial real estate -- 5% in treasury bill/bonds can you imagine the devastation and havoc that would spread throughout the real estate industry -- the national economy? Bill Gross' opinions of headline inflation (CPI) is actually closer to the global 7% rate and he is not alone in his thinking. An article was written in the Wall Street Journal by David Ranson, head of research at H.C. Wainwright & Co. Economics titled "Inflation May Be Worse Than We Think." He too believes the "headline" consumer price index should be viewed with skepticism. The root of the confusion is the fact that the prices consumers actually pay change far more quickly than the CPI. His article goes on to claim, historically, CPI inflation is more closely related to prior changes in the price of gold than most people realize.
"There is a remarkable parallel between annual CPI Inflation and the cumulative change in the price of gold measured from eight years before".
This statement is worth its weight in gold...pardon the pun, but it gives an excellent formula for forecasting future inflation (or, correct inflation for us gold-bugs). Here's David Ranson's formula and calculations:
225% appreciation in gold ('2000-'2008)/80=2.8% + 3% = 5.8% Inflation
This formula above is the rule of thumb used by Ranson to estimate CPI Inflation at any given time: Divide the percentage change in the gold price from eight years in the past by 80, and add three. In the last eight years the price of gold has risen 225%. The rule therefore comes out with an answer that puts inflation a lot closer to 6% than 4% currently quoted. This makes perfect since as the U.S. Dollar has depreciated nearly 30% versus its competitors since the late 90's.
The Effect....Higher Treasury Yields and Cap Rates!
Can you imagine the consequences if investors some day woke up and realized that their compensation for risks were too low?. That the U.S. Government had understated the real rate of inflation? As everyone rushes to the exits...you would have simultaneous bouts of inflation and deflation in real estate. Lenders would adjust mortgage rates abruptly -- Spreads to them would nearly double and entry cap rates would need to increase immediately in order to regain positive leverage in real property values. Here are more possibilities...I bet you can think of others:
- Exporting countries would stop buying U.S. Treasuries increasing yeilds
- Gold prices begin to spike towards $2,500 per oz.
- Increased demand for real estate with short-term leases (Apartments!)
- Slacking demand for real estate with fresh long-term leases (Industrial, Retail)
- Increased demand for real estate with expiring long-term leases
- Difficulties in refinancing as values fall
- The drop in consumer spending would deepen (hurting Retail further)
- The return of creative financing as traditional sources become scarce
I'm sure your imagination can go on and on, or your memory of the early 1980's will flash before your eyes and you have to say...what is this real estate really worth?
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