I was wondering if someone could explain the effects of inflation on cap rates. The way I understand is that inflation will increase your income and your expenses so the net effect on NOI will be close to null resulting in an unchanged cap. Am I correct?
Thanks.
Interesting question...no straightforward answer.
Your math on the NOI is incorrect. Assuming you make a profit...then inflating revenue and expense at the same rate will result in the NOI growing at the inflation rate as well. Thus, higher inflation has a positive, not null, effect on NOI.
I can think of two main effects of inflation on cap rates. I think the most prominent effect is exhibited as a result of the effect inflation has on interest rates. Generally, higher inflation expectations push nominal interest rates up. Cap rates have, at least in recent history, typically exhibited premiums to prevailing interest rates (with particular correlation, some say, to yields on BBB corporates). Thus, by way of interest rates, one might argue higher inflation would drive cap rates higher.
On the other hand, that analysis ignores the point regarding inflation's impact on NOI, which you noted. Inflation increases NOI, and stronger NOI growth projections result in lower cap rates. This logic has empirical support, as cap rates in the pre-90s era of high inflation often represented discounts to prevailing bond yields, a rare occurrence today.
Thanks for the thoughtful response. In the spirit of debate, and theoretically, do you think that inflation will only affect inominal[/i] NOI, and not impact ireal[/i] NOI? If I think about that, then it seems that inflation-driven NOI should not drive cap rates for precisely that reason -- increases in cap rates are not mathematically needed to keep property values in-pace with inflation (assuming perfect economic agents make up the marketplace). Is this wrong? I might be missing something or misunderstanding here, but it seems inflation expectations should not drive real values, given neo-classical assumptions... Until interest rates are brought into the picture--a point you well-articulated.
Also, I'm not as well-versed in the history as I should be, but based on my readings, I thought the pre-90s cap rates were largely explained by the tax environment of that period of time?
edit: reibny got this one. I hit "reply" on a page that I hadn't refreshed in like 24 hours.
To clarify, the "nominal" vs "real" distinction is one that can be applied to growth (e.g. "NOI growth"), but not the base item itself. By definition, inflation has no effect on real growth, so inflation will only affect "nominal NOI growth."
In any case, I believe the conclusion you've drawn is incorrect. First of all, I'm not sure how you can evaluate value in a "neo-classical" framework without contemplating interest rates (or some other contextualizing risk-free rate). After all, in a world without investment alternatives, no one can say what values would be, and that's fine since the answer is irrelevant. Further, it stands to reason that in a macro environment of increased inflation, inflation-protected assets such as real estate and equities will perform better than their unprotected peers (fixed-rate bonds), and this will inevitably affect valuation multiples for these assets.
Certainly the tax environment of the 80s had major implications for the attractiveness of real estate as an asset class. Nevertheless, high rates of inflation were also a significant contributing factor to the inverted relationship of cap rates and interest rates during that era.
Exactly, so inflation does not drive real prices, by definition, unless one were to distance oneself greatly from neoclassical assumptions and be quite intertemporally- and macro-focused. On the other hand, interest rates and inflation can have affects on nominal and relative values of the asset, as you said, as they're better-protected from associated risk. I think that's what I was trying to articulate -- that I don't understand how the underlying real value of a RE asset can be increased simply by increasing only nominal NOI without increasing real NOI, ceteris paribus... But maybe I'm wrong, because you're smarter than I am on this.
If we consider the cap rate to be defined as discount rate - growth rate, from the equation that represent perpetual growth of cash flows, Market Value = Current NOI / Cap Rate, higher inflation would push up the growth rate and generally high inflation is associated with low rate environment, which leads to lower discount rates. So Discount Rate (Dec.) - Growth Rate (Inc.) = Cap Rate (Dec.).
AKA lower cap rates and higher market values in inflationary times.
To kaorder, you're right except that high inflation is usually associated with a HIGH rate environment, as investors will demand higher yields to compensate for the time-value of money in a period where inflation is rapidly eroding the future spending power of those dollars. Further, government policy prescription for high inflation is typically to raise rates and sop up excess liquidity. As a result, inflation creates opposing forces in your equation: it will raise the base discount rate, but also raise the rate of expected growth. The net impact on cap rates is therefore in question.
Econ, I think you are mixing up terminology but may have a sound underlying point. You need to stop referring to present day values as real vs. nominal, as the distinction only applies to rates of future growth. An asset worth $100 today is $100. Period. An asset that makes $10 today makes $10. Period. No real or nominal components. But the argument that inflation alone would not drive asset value increases is supportable if you posit that real discount rates remain flat regardless of shocks to expected inflation (which is fair). Then, an increase in expected inflation would be fully offset by an equal increase in nominal discount rates.
I have done some research on the matter, and it seems that on the question of which opposing force dominates (inflation-driven increases in NOI driving down cap rates, or inflation-driven increases in interest rates driving up cap rates) the empirical evidence sides slightly on the NOI side of the equation. Since 1978, there have been six periods of rising interest rates (each cresting below the prior crest). In two of these periods cap rates remained flat, in two they rose almost imperceptibly, and in two they fell noticeably. So on balance the positive impact on value of rising NOI expectations overwhelmed the negative effects of increasing nominal discount rates.
I see what you're saying long term. However, my point of contention is the fact that inflation, which is generated by increases in the money supply, are dictated by incentivizing the population to spend rather than save. Long-term, I agree that government intervention will tend to be increasing rates to combat the problem of inflation, but one of the major causes of it is the impact of low rate environments. Using the model I described above does over simplify the problem and it would be better suited to incorporate forward looking expectations. Food for thought.
Thanks for the insightful information.
@econcomputingcre, going back to your point about inflation and real estate prices. Inflation would definitely drive prices up or the dollar value of your investment if you were to buy in a low inflation environment like today. If inflation increases in 5 years, ceteris paribus, your assets would be worth more since inflation and your dollar would be worth $(1+i)^n
Inflations affect on NOI is the most important factor – after all, you can’t capitalize a negative income stream. This is a broad question and varies by region, asset class, operator, and every other small factor that effects real estate.
In today’s day and age with interest rates at record lows and inflation looming above us, one would assume that interest rate hikes are inevitable and that these hikes will drive up (already) compressed cap rates to higher levels in order to sustain investor returns.
This terrifies me. 5 cap core office assets are going to get CRUSHED as soon as the inflation time bomb starts ticking. The good news is that all the distressed shops that opened in the downturn will have another feast on defaulted debt in 2 - 3 years.
In addition to the sub 4 cap multifam assets moving in San Fran
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