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Deflation Risk and Commercial Property Appraisal

Article:
(This archived article was published in 2012.  More recent data is found in the articles section of our web site). There appears to be a tug of war right now between inflation and deflation in our economy. At first blush many people assume that inflation is the greater risk. They see massive government deficits and governments madly printing money with quantitative easing programs that pump hundreds of billions of dollars into the economy. It doesn't take a rocket scientist to figure out that if you print massive amounts of money the dollar is worth less which creates inflation and higher interest rates. Higher inflation means higher interest rates which hurts the cash flow of commercial properties and thus their value. Please see our article "Could Property Values Drop Further" on this web site which looks at the implications of higher interest rates on commercial property values. The argument for deflation, however, is a little more subtle but compelling. One way for money to be created is by the Federal Reserve through programs such as quantitative easing. Another more powerful way to create money is by consumers or the government going to a bank and borrowing money. A bank can take deposits and then lend out far more money than they actually have. Many banks require 20% down and then essentially create the additional 80% through a loan which expands the money supply 5 times. For most of the last decade from 2000 on the governments of the world have been running large deficits with their stimulative effects. The private sector has been borrowing and leveraging like crazy creating the largest real estate bubble in history. From the year 2000 through 2006 housing prices over doubled and mortgages went from 3.3 times after tax income to over 9 times after tax income in the same period Total U.S. private debt climbed to 42 trillion dollars and government debt went to 14 trillion. The U.S. virtually tripled its credit availability in only 6 years. According to the Federal Reserve, Household Net Worth was about 66 trillion in 2007. After the housing crash, household net worth dropped by 18 trillion through 2009. This massive drop in net worth and housing prices has resulted in a massive contraction of the credit markets. As everyone deleverages the extra capital simply disappears. The baby boomers are getting older and starting to retire en masse. As boomers move toward retirement they move from a consumption mode to a retirement preparation or saving mode. This is part of the reason that even when the government drops interest rates it isn't having as big an impact. If you are 60 years old you aren't going to be a big consumer no matter what the rates are. Rational retirees or near retirees should be shedding debt not adding more. They are saving more and borrowing less no matter how cheap the money is. The government is now even more broke and can't afford to keep stimulating the economy. A few trillion in government stimulus and printing money cannot hold off the massive deleveraging of the private sector economy. This deleveraging is creating a powerful negative cycle that keeps feeding on itself resulting in less consumption, more unemployment and a continued decline in property values. With expectations of continued commercial property value stagnation or decline people are reluctant to purchase feeling they can get a better price a few years down the road. This further feeds the negative cycle. This is similar to what happened in Japan which has been floundering for a decade. Many economists still believe that inflation is the greater risk than deflation. A substantial number, however, think that deflation if the greater risk. Once deflation starts it can be very difficult to stop. If this scenario plays out it could lower the velocity of sales transactions as people just wait it out. It could also result in a tendency toward property over-assessment since the assessor uses historical sales in establishing property values. Chicago area commercial appraisers need to monitor inflation/deflation expectations as they can impact property valuation.

J. Chie, Esquire

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