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Is Inflation Stubborn?

By Clay Grubb, CEO, Grubb Properties

June 10, 2024

I find it vexing that the Federal Reserve has adopted the terms “transitory” and “stubborn” to describe inflation. Inflation simply reflects an imbalance that occurs when demand outstrips supply. But when it comes to housing, one of the country’s most critical assets, the central bank has inexplicably chosen to focus on dampening demand rather than boosting supply.

Following years of restrictive home lending policies, the Fed’s recent actions have made it even more elusive to achieve the enduring American Dream of owning a home. This demise of the American Dream is not healthy. The middle class is disappearing and economic mobility for those in the lowest income brackets is almost nonexistent. Home ownership provides a critical vehicle for economic mobility.

Inflation Stubborn

Following the Great Financial Crisis, mortgages became extremely difficult to obtain for would-be borrowers who could not afford one under the conventional definition. The idea that you must put a 20% deposit down on a home to be a good credit risk is a farce. The reasoning behind the 20% down payment concept is that people with more equity in their homes are more likely to make mortgage payments on time. But a JP Morgan study showed that the behavior of homeowners during the Global Financial Crisis was identical whether or not they had equity in their home. Rather than equity, the most significant factor was whether a homeowner had access to cash. If they did, they paid their mortgages; if they didn’t, they didn’t, regardless of whether they had equity in their homes.  Furthermore, over 100 million American renters choose to make their rent payments on time each month despite not having any equity in the property. So why do we think Americans would behave differently if they owned their home and could enjoy a range of benefits including  tax breaks, and opportunities to build credit and wealth? 

Beyond this, current Federal Reserve policies have caused the monthly cost of homeownership to jump to an all-time high. According to CBRE’s latest study, the monthly cost of purchasing a home exceeds renting by 52%. 

Inflation Stubborn

According to Redfin, just 15.5% of homes on the market last year were within the budget of the average American, the lowest housing affordability ever recorded in U.S. history.

Restrictive home lending policies and elevated interest rates have made becoming a homeowner close to impossible for many of these 100 million renters. At the same time, renting also has become more expensive. The Global Financial Crisis wrecked the housing industry, resulting in years in which significantly fewer housing units were built and were far exceeded by the number of new households created. This triggered a tremendous amount of rental inflation over the past decade.

This started to change coming out of the COVID-19 pandemic as we saw an encouraging increase in the number of apartments under construction. In fact, 2024 is on track to have the greatest number of new deliveries for any single year since before the Global Financial Crisis. The result was that many renters saw a dramatic increase in concessions this spring, and some are seeing declines in their rent. To me, this should be welcome news to a central bank that’s battling inflation. But sadly, Fed officials are taking the contrary approach to what is taught in Economics 101. Simply put, there are two ways to battle extreme inflation. One is to dramatically increase new supply, which seemingly occurred two years ago and resulted in record apartment deliveries. The other is to dampen demand, which is the unfortunate and counterintuitive route the Fed has chosen. For some reason, the Fed seems to believe that attacking demand for housing is more impactful in thwarting inflation than boosting supply – and at a time when we are seeing the first relief in rental prices in over 15 years.

Fed policies are especially concerning because they have eliminated the supply of financing that allows for new construction starts. In fact, CBRE predicts that America will experience a 70% decline in new multifamily construction starts from the 2022 peak. In a country that is short almost four million homes, it would seem the elimination of new construction is a poor policy.

My company, Grubb Properties, is a leading developer of comparatively affordable apartments in urban markets. The Fed’s actions have forced us to pause development work on the plans for over a dozen new potential apartment developments  and refrain from pursuing any new development opportunities for the next several years. We are not alone. I get correspondence almost daily from my brethren in the apartment industry struggling to make ends meet, with many facing some type of real estate foreclosure.

To understand the impact of the Federal Reserve’s decision to increase interest rates 2,000% over the past two years, consider the following. An apartment community that generated $3.5 million in net income in 2021 would have been valued in early 2022 using around a 3.5% cap rate. To compute the value, you divide the current net income by the cap rate, meaning a property with $3.5 million in net income would have been worth $100 million. Today, I believe the market would value that same property using a 5.5% cap rate because higher interest rates make it significantly more expensive to borrow. Using the same math, that property’s value plummets to less than $64 million.
This example does not reflect the fact that most developments are financed with floating-rate debt, meaning developers were likely paying about 4% interest on their loan two years ago and now are paying 9%. If a developer borrowed $50 million for that project, a conservative amount of leverage, their debt service costs have increased from $2 million annually to $4.5 million. This results in an annual loss of $1 million, meaning developers are now unable to service the debt on their property. Owners are losing money and must come up with additional equity each month to service their debt. 

But the fact is, many developers use more leverage for developments than in my conservative example of 50% loan-to-value. The same project above would likely have used more than $65 million in debt, meaning the change in value completely wiped out the investors’ equity and they may be facing foreclosure. If these apartments were seeing high rental growth rates, there might be some hope. But most are seeing rental rate declines and very few are achieving their initial return projections. 

Interest rate increases have not only resulted in significant losses throughout the entire commercial real estate industry, but they have also scared new sources of equity from being willing to invest in the industry. According to S&P Global, 2023 saw the highest number of bankruptcies since 2010. If this spills over into the real estate industry, there will not be enough companies left solvent to develop the necessary supply to keep up with demand, likely producing another decade of runaway rental costs. It took more than a decade for our industry to recover from the Global Financial Crisis. The current decision to put suppliers in our industry and many developers out of business is going to have a disastrous impact on the costs of a home for Americans for a long time.

It is not all bad news. The current boost in new supply has resulted in rental inflation below 2%. According to Yardi Matrix, one of the most detailed databases in the country for current apartment rents, in May 2024 asking rents had increased only 70 basis points (0.70 percentage points) from this time last year. In fact, in May of 2023, Yardi reported that asking rents had increased by less than 3% from the prior year. These milder rental increases do not incorporate a significant number of the concessions that are prolific in the rental market today, which make renting the cheapest it has been in over three years.

The slowdown in rental costs should be welcome news for the Fed in their efforts to stall inflation and the market in general. However, I recently learned from listening to Willy Walker, CEO of Walker Dunlap, interview Peter Linneman, the Wharton Economist who specializes in real estate, that the rental index used by the Federal Reserve to compute the Consumer Price Index is partially determined by calling homeowners and asking them what monthly rent they would pay for their own home. This may have been a logical strategy 50 years ago, but in the age of modern data, why do they still use this antiquated approach? The actual data shows that rental increases are below the Federal Reserve’s targeted 2% inflation. But as you can see from the chart below, central bank officials curiously claim rental prices are up 5.9%. 

Bureau of Labor Statistics
Source: Yardi Matrix, Moody’s Analytics, Bureau of Labor Statistics

At Grubb Properties, we are focused on performance for our essential housing portfolio. During the COVID-19 pandemic, our portfolio of apartments received over 98% of our rents every single month of 2020. We ended that year with the highest occupancy and highest rents in our company history. Today, we are seeing deflation throughout our portfolio as revenues and real rents are declining. While that is the reality on the ground, it seems each day a new Fed official declares that inflation is stubborn and they must keep rates higher longer.

As we entered this period, I warned our investors that rates would be held higher longer, not because they needed to, but because that is historically what the Federal Reserve has done. During the COVID-19 pandemic, they kept rates too low for too long, stoking inflation while saying that inflation was “transitory.” Now they are keeping them too high for too long, saying inflation is “stubborn.” They seem to have little ability to look ahead through the windshield, rather than the rearview mirror, to help us navigate the ups and downs of our economy. Instead, they rely solely on historical data, and flawed data at that. Americans are cutting back on spending and we are starting to see price reductions throughout the economy. Yet Fed officials remain tethered to the “inflation is stubborn” bandwagon, likely because no one wants to stick their neck out to say anything to the contrary.

Learning starts by being open to the idea that maybe we just do not understand everything. I write this letter in the hope that members of the Federal Reserve will realize that destroying the creation of housing supply is the surest way to guarantee inflation is here for a very long time, which is the exact opposite of what underpins a healthy economy. I ask the Federal Reserve Board officials to please stop worrying about what inflation is at this very moment and focus on what inflation will look like tomorrow. Let’s figure out how to boost supply of one of our most critical assets: housing.

Clay Grubb

Chief Executive Officer of Grubb Properties