Commercial Real Estate Blog

For the first time since the dot-com era of 1999-2001, inflation rates in the San Francisco Bay Area have increased at more than a 4.5% annualized rate. Many tenants over the past several years have accepted CPI as the determining factor for annual rent escalations. For several years, the CPI method paid off (assuming a 3% floor was not agreed to) since the CPI rose by around 2% annually.

But now, increasing energy and fuel costs have had a dramatic effect on inflation. As a result, the most recent 12-month increase in the Consumer Price Index came in at 4.7%. The CPI index is based on San Francisco Urban Wage Earners and Clerical Workers. Savvy landlords generally utilize this index instead of the All Urban Consumers because it rises faster.

As a tenant, it is always best to fix escalations, particularly when macroeconomic trends point to inflation. If inflation-indexed escalations must be utilized, then it is important to cap the increases under the lease (5% is typical in today’s market, but if inflation continues to rise, then that could go out the window).

The chart below provides a 10-year history of the CPI index for the San Francisco Bay Area.

The manager of the world’s largest bond fond, the Pimco Total Return Fund, says that the methodology the United States uses for calculating its inflation rates results in an understatement by roughly 100 basis points. This results in real GDP growth and real bond yields to be off by a similar amount.

If the calculation was done in conformance with how much of the rest of the world calculates its inflation rate, then not only would bond investors seek higher returns, but property investors would also require a higher return or cap rate when looking at real property investments. A 100 basis point difference in the cap rate represents a significant difference in price and that is where the risk would lie for property owners.

His concern or comments seem to lead back to the diminishing pricing power the U.S. has in the global global market; if investors beging to require higher returns to offset inflation, then there will be few options but to comply.

As always, there is a catch to the theory. Bill Gross is a smart guy and all, but to assume that there has been a mispricing of debt in the markets for decades is, at best, a stretch.

Whether Bill Gross is right or not though, I’m sure anybody who has bought milk or pumped gas lately would argue that inflation is in fact running higher than purported.