The Significance of PPI in Commercial Real Estate and Inflation

The Bureau of Labor Statistics announced Wednesday that the prices received by goods and service producers increased at the quickest rate since records have been maintained in March. The producer price index, which gauges wholesaler prices, rose 11.2 percent from a year earlier, the highest increase in a data record dating back to November 2010. Monthly, the index rose 1.4 percent, beating the Dow Jones expectation of 1.1 percent and setting a new high. When food, energy, and trade services are excluded, the so-called core PPI gained 0.9 percent every month, roughly double the 0.5 percent projection and the largest monthly advance since January 2021. On a year-over-year basis, the core PPI climbed by 7%. PPI is a forward-looking inflation indicator since it measures pricing for products and services that will eventually reach consumers. The data was released the day after the Bureau of Labor Statistics revealed that the consumer price index for March increased by 8.5 percent year over year, exceeding forecasts and reaching its highest level since December 1981. On the producer side, final demand goods prices increased by 2.3 percent month over month, while services prices increased by 0.9 percent, a considerable increase from the 0.3 percent increase in February. During the Covid epidemic, goods inflation outpaced services, but March’s figures show that services are already catching up as consumer demand swings. Energy prices jumped by 5.7 percent during the month, while food prices increased by 2.4 percent. The Federal Reserve has begun tightening monetary policy in response to rising inflation. The Federal Reserve raised its benchmark short-term borrowing rate by 0.25 percentage point in March, the first in a series of hikes planned throughout the year. Markets are fairly likely that the Fed will double that move at its May meeting, and that it will continue until the Fed funds rate reaches approximately 2.5 percent by the end of the year. Markets were initially unresponsive to the PPI announcement, with stock market futures remaining unchanged and Treasury rates remaining unchanged. 

But what does most of this information mean, and why is the PPI so important?  

After unemployment statistics, inflation is perhaps the second most closely followed indicator, since it aids investors in predicting the future direction of monetary policy. Because it can act as a leading indication for CPI, the core PPI can play numerous functions in enhancing investment decisions. When producers confront growing input prices, such expenses are passed on to retailers, who then pass them on to the customer. Furthermore, the PPI depicts inflation from a different perspective than the CPI. Although consumer pricing fluctuations are significant, tracking PPI helps one to know what is behind the changes in CPI. If the CPI rises at a significantly quicker pace than the PPI, for example, this might imply that merchants are raising prices for reasons other than inflation. Retailers may just be seeking to retain their operating margins if CPI and PPI both rise simultaneously.  Usually, in commercial real estate, the PPI is crucial to be at the same level as the CPI. Owners are taking advantage of it by adjusting the clause in the lease and having a cap.

In the CRE industry, inflation resiliency varies by asset type, and it is mostly determined by how quickly and frequently the property owner may modify rental prices.

The shorter the lease period, the faster an owner can adjust rents to keep up with rising inflation–in theory, the shortest relative lease durations are found in hotels, multifamily, and self-storage. On the other hand, an N fully leased asset on a longer-term lease with fixed rent increases would lock the investment into a strict rent schedule, providing little to no potential to boost NOI and mitigate inflationary effects.

A major retailer, such as Starbucks or Walgreens, or a single-tenant industrial transaction leased to Amazon on a long-term lease, would fit the bill (20-30 years).

Finally, modifying the NOI can assist protect the true value of future cash flows and, ultimately, investor returns by increasing a property’s cash flow to be commensurate with inflation. Because most real estate assets appreciate over time, many investors are frequently well-positioned during periods of rising inflation.

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