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INFLATION’S IMPACT IN THE 1970’S

This article explores how inflation affects existing and new development real estate differently. It covers the short-term impact on financing costs and the costs of goods and services, as well as the long-term impact of excess demand and new incentives to develop. It also discusses the three elements that protect real estate parcels from cyclical vagaries: strength of the market, nature of lease contracts, and financing rates and terms.

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INFLATION’S IMPACT IN THE 1970’S

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  1. WINNERS BORROWERS INVESTORS IN REAL ESTATE INDIVIDUALS WITH HIGH SKILLS AND/OR JOB MOBILITY INDIVIDUALS EMPLOYED IN GROWTH AND HIGH-TECHNOLOGY INDUSTRIES MOST GOVERNMENT TAX COLLECTORS LOSERS LENDERS INVESTORS IN FINANCIAL ASSETS INDIVIDUALS WITH FIXED INCOME AND/OR NO JOB MOBILITY INDIVIDUALS IN MATURE AND/OR ENERGY-INEFFICIENT INDUSTRIES MOST TAXPAYERS AND SAVERS INFLATION’S IMPACT IN THE 1970’S

  2. THE WEALTH TRANSFER EFFECTS OF INFLATION

  3. EFFECTS OF INFLATION ON EXISTING-PROPERTY ECONOMICS

  4. WHY MAY INFLATION AFFECT EXISTING AND NEW-DEVELOPMENT REAL ESTATE DIFFERENTLY? • SHORT-RUN IMPACT • COSTS OF FINANCING • COSTS OF GOODS AND SERVICES • INTERMEDIATE IMPACT • VACANCY RATES FALL • RENTS INCREASE • LONGER RUN IMPACT • EXCESS DEMAND • NEW INCENTIVES TO DEVELOP • CYCLICAL SWING BACK (MAY OCCUR)

  5. THREE ELEMENTS TO PROTECT REAL ESTATE PARCELS FROM CYCLICAL VAGARIES: • STRENGTH OF REAL ESTATE MARKET • NATURE OF LEASE CONTRACTS • FINANCING RATES AND TERMS

  6. GRAPH FROM III-56

  7. IMPACT OF INFLATION, BY LAND USE • URBAN LAND • AGRICULTURAL AND FOREST LAND • RESIDENTIAL PARCELS - OWNER - OCCUPANT UNITS - MULTI-FAMILY PARCELS • COMMERCIAL SPACE

  8. INFLATION AND MACRO-CYCLES AND REAL ESTATE INVESTMENT STRATEGIES • LONG CYCLES • WENZLICK • CASE • SHORT CYCLES • CONSTRUCTION CYCLES • MORTGAGE AVAILABILITY CYCLES • OTHER CYCLES • URBAN AREA / CITY CYCLES • NEIGHBORHOOD CYCLES • PROPERTY-SPECIFIC CYCLES • NEW CONCEPT / OVERKILL • HOT MARKET / OVERKILL

  9. EXHIBIT 7-10

  10. ECONOMIC RISKS RELATE TO THE EXTENT INFLATION IS PROPERLY ANTICIPATED VERSUS UNANTICIPATED

  11. IMPORTANT INFLATION RELATED CONCEPTS • ANTICIPATED VS. UNANTICIPATED INFLATION • RELATIVE REAL RATE OF RETURN AMONG VARIOUS ASSETS - REAL ECONOMICS - TAX EFFECTS

  12. EXCEL CHARTS

  13. EXPECTED INFLATION, REAL AND NOMINAL INTEREST RATES, AND CAPITAL MARKET EQUILIBRIUM • A CHANGE IN THE EXPECTED RATE OF INFLATION MAY CHANGE THE REAL RATE OF INTEREST • CHANNELS FOR THE CHANGE IN THE REAL RATE OF INTEREST ARE: - INCOME SAVINGS EFFECTS - WEALTH EFFECTS • NOTE: THERE MAY BE DIFFERENCES IN SHORT RUN VERSUS LONG RUN IMPACTS OF CHANGES IN INFLATION.

  14. INFLATION AND THE AFTER TAX REAL RATE OF INTEREST

  15. LENDER RETURN UNDER INFLATION: EXAMPLE • ASSUME: • DESIRE 2% REAL RETURN AFTER TAXES • IF NOMINAL RATE IS 12% AND THE EXPECTED INFLATION RATE IS 10%, WHAT IS THE REAL RETURN FOR THE LENDER? • LENDER IS IN 50% TAX BRACKET

  16. INFLATION AND DEPRECIATION: THE FIRM • NET AFTER TAX REAL REVENUE FROM INVESTMENT PROJECT • = (1 - TAX RATE) X (SALES REVENUE - PRODUCTION COSTS) • NOTE: • GENERAL INFLATION HAS NO REAL IMPACT IN PRINCIPLE! • BRACKET CREEP CHANGES CONCLUSION • DEPRECIATION EFFECT ALTERS INCENTIVE TO INVEST • In sum, the firm will require a lower real rate of return (i.e., and cost of financing) if high inflation persists. Hence, as inflation increases, nominal interest rates must rise less than the change in the inflation rate.

  17. INFLATION AND THE AFTER-TAX REAL RATE OF INTEREST • INSERT

  18. INFLATION AND DEPRECIATION • INSERT

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