Pollination of Commercial Real Estate

As spring and summer fill our senses with visual and olfactory cues, words from commencement speeches remind us that this beauty comes from the work of bees.  This week, Bernanke’s speech at Harvard University made this connection covering economic issues such as monetary policy, inflation and economic transfer.

Replacing the complacent tone of commodity pricing to commercial real estate could take the speech in another direction.  To believe history does not repeat itself and that monetary policy tools are in place for inflation not to jump 6% is a bold statement.  Although the strength of inflation may seem manageable, its energy is not.  The fact that we have new devices to redirect or diffuse the energy does not minimize its effect, rather, it redirects the energy through another vehicle.

With regard to interest rates, the commercial real estate market has added the first layer of protection using interest rate swaps.  These devices are like rolling platforms, providing stabilizers to the building footing during the volatile movement of the interest rate market.  To what level they have been tested is still unclear.  With recent downgrades of MBIA and AMBAC, we have seen support break through AAA ratings and fallout at AIG.

With rising inflation, the situation plays out in commercial real estate above ground. Recent levels of potential inflation on the horizon are being watched, and the available protection from the market to inflation is more limited.  Landlords will be dependent upon pricing power to pass along cost to tenants or they will have to absorb the differential.  Tenants will have to pass rising costs onto their customer base or absorb the cost differential.  Higher levels of efficiency (through cost cutting) and higher levels of productivity do not change the pricing of inflation.  At some point, one of the parties will have to bear this economic transfer.

Bernanke claims that times are different since the economy is more flexible; however, buildings are still made of bricks and mortar.  Unless we have second and third layers of protection to manage inflation and rent, the commercial real estate market remains at risk to these physical limits. Price increases will return to manageable levels with landlord and tenant default and vacancy correction.

Without the use of real estate derivatives, imagine the comparative shock of oil rocketing up 400% since 2003 in real estate terms.  With these increases, the numbers are extended for multiple time periods of five to ten years with long-term leases.  Although the price of oil may retreat below $100 in the next few months, these conditions do not exist for the tenant and landlord.  We want the flowers, we need the bees, and so it might be prudent to have the antihistamine in the pocket for when we inevitably get stung.

With the introduction of modern fundaments, we are seeing an opportunity to manage these risks.  Commercial real estate is a multipart reflection of the economy and options on interest rates, inflation and rent begin to get the Adam Smith going in all of us.