Inflation Station?: A Response to Jeff Lacilla on the Future of Real Estate Values

Another piece from the Slatin Report, where Lawrence Fiedler, a colleague of Jeff Lacilla, comments on his article "What Price Value?" (posted here on March 9th).

What he basically says in the end is that people are predicting that inflation will go up, placing a strain on the economy (as in a recession in the next 12-18 moths) and that this will have a negative effect on the industry - unless there is some surprise in the next 10 years. With this he bolsters Lacilla's argument that real estate values are due for a decline in the near future
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FINANCE NYC 04 05 06

INFLATION STATION? by Lawrence E. Fiedler


I read with interest the article by Jeff Lacilla in the March 2nd issue of The Slatin Report, "What Price Value?" Mr. Lacilla assumes that the inflationary pressures brought about by increases in commodity prices such as oil, along with the Federal deficits resulting from the Iraq war and the war on terror, will lead to higher short and long term interest rates and consequently a reduction in property prices.

We presently are experiencing a near yield curve inversion (where short term Treasury interest rates have moved above the 10-year Treasury rate). Bill Gross of PIMCO, one of the largest U.S. bond firms, stated in Pimco's January 2006 newsletter that inversions such as what we are now going through have historically preceded U.S. economic recessions by 12 to 18 months. If history is in fact a precursor of the future, as Mr. Gross believes, then we will be seeing a substantial slowdown in our economy by the end of 2007.

The 10-year Treasury interest rate has long been the base rate for all long-term investments. Historically within that rate has been the public attempt at recovering perceived future inflation-driven asset-value losses, plus approximately a 1.5% to 2% non-risk real internal rate of return. This non-risk real internal rate of return has never fluctuated materially during the past 50 years. Therefore, the key moving element within the 10-year Treasury has been the perception by investors of the average annual inflation rate for the next 10 years.

A recent study by a major financial institution concluded that the present risk premium (the Internal Rate of Return historically being projected on newly acquired assets) in excess of the current 10 year Treasury rate (3%-4%) is very close to the historical risk premium they have projected for new acquisitions in the past. In other words, when the 10-year Treasury was 13%, risk premiums reached another 3% to 4% above that to 16% to 17%; today, with the 10-year Treasury at about 4.8%, projected Internal rates of return for new assets are now roughly 7.8% to 8.8%.

The conclusion that I draw is first that the public perception of inflation for the next 10 years is now about 2.8% to 3.3% (4.8% Treasury rate less a 1.5% to 2% non-risk real rate of return). Inflation perceptions are a result of all the current commentaries and gut feelings by investors today. The prediction of a future recession is also being taken into account today. If the value of real estate is mainly predicated on the perception of future inflation, this perception will only change if a surprise event occurs that changes the 10 year inflation expectations of the investing public. Obviously, any circumstance being discussed now has been taken into account. It is only those possibilities (surprises) that we are not aware of that will change the perception of future inflation and therefore the future value of real estate.


Lawrence E. Fiedler is the president of JRM Development Enterprises Inc., a real estate investment concern in New York City. As an adjunct professor, he taught real estate investment and finance at New York University for more than 27 years. Jeff Lacillla, who also teaches real estate finance at NYU, is a managing director at JRM Development Enterprises.