Q&A with Rick Pederson, Vice Chairman of Bow River Capital
The U.S. economy at midyear is booming, but costs are moving just as fast. U.S. CPI jumped 0.9% on both the headline and core rates in June, surprising many. The June monthly headline is the largest surge since 2008, while the core reading is the biggest gain since late 1981, according to Labor Department data.
Rick Pederson, vice chairman and chief strategy officer of Bow River Capital, shares his views on inflation’s impact on commercial real estate in the Rocky Mountain region. Bow River is a Denver-based alternative asset management firm with $1.3 billion under management as of June 30, 2021.
1. Inflation has been a hot topic this year. Any inflation surprises from July’s consumer data?
We at Bow River were more relieved than surprised at the July data. The month-over-month CPI-U number in July (.5%) fell from the June statistic of .9%. Even though the annual inflation index remains high at 5.4%, we believe much of this is attributed to “base effect,” misleading percentages that result from comparing current data to the depressed mid-pandemic conditions of 12 months ago, such as higher airfares, restaurant checks or hotel room rates. Another temporary impact is used car price increases, which account for approximately one-third of the CPI’s increase. As of July, airline fares and furniture prices fell slightly while price gains for apparel and used cars appear to have peaked.
It is worth noting that annual inflation in the Denver-Aurora-Lakewood area increased only 3.5%, significantly less than the national average of 5.4%. Our local economic conditions were somewhat better during the pandemic than elsewhere in the U.S., so the base effect is not as pronounced. Other cities are seeing higher price increases in categories like gasoline and food. Importantly, apartment rents are not rising as fast in the Denver metro area, which may be linked to the pace of new, local supply. However, the CPI input of “owners equivalent rent” (the implied rate of renting one’s dwelling) is escalating more quickly in Denver than national averages. This is not surprising if you consider that it’s a closer proxy to the escalation in Metro Denver house values.
2. The Fed has said that many inflation inputs are transitory, do you agree with that? Can you provide a relevant example of transitory inflation in local commercial real estate?
Many of these trends are tied to component shortages and supply chain bottlenecks and are either reversing fast or will ease gradually over the next year. For example, in construction, we’ve all heard about skyrocketing lumber prices. An estimated 10% of pulp and paper processing facilities in the U.S. scaled back production between March and September of last year; at the same time, wood imports from Canada were restricted. However, the supply squeezes and buying frenzy of this spring are now winding down. From their May peak at $1700/thousand board feet, softwood has fallen to around $500 today. We expect lumber prices to keep trending lower as sawmill capacity rebounds, perhaps to $450 next year…about the same as 2018-2020. Steel prices, on the other hand, are likely to remain a bigger problem. U.S. raw sheet steel pricing quadrupled in the last nine months ago and is hovering close to its May peak. Because steel demand comes not just from building construction but also from the auto, aircraft, infrastructure, and machine sectors, boosts to processing capacity will probably not let the air out of prices for at least another year.
We saw something like this in 2008-09 when the Great Recession interrupted supply lines for construction materials. For example, new warehouse building costs increased about 7% starting in late 2008, then settled back to previous trendlines the following summer. We think the same might happen again; however, this time the cost relief will not quickly retract to 2019 levels, with some materials prices staying higher for longer, and as the wage component of inflation weighs in with a more pronounced mismatch in job requirements versus worker skills today than existed in 2009.
3. How does Bow River see inflation impacting commercial real estate in the Rocky Mountain Region?
We are not observing a direct slowdown in the pace of construction specifically linked to materials price inflation, at least in commercial product types. In markets where Bow River is building—Nevada, Idaho, Utah–pent-up demand from tenants is lifting rents as fast as costs. We know this rent inflation cannot be indefinitely maintained, but we also believe that cost inflation will moderate.
While we’re monitoring wage inflation, we aren’t seeing significant wage inflation appear in government data, with average hourly earnings for all U.S. workers up a little over 3% in the last year. Specifically, we have yet to find serious increases in construction employee costs overall. According to BLS data wages paid to all construction workers are roughly 4% higher than one year ago, and building tradespeople in roofing, concrete, electric, mechanical systems—as well as in architecture and engineering—have seen annual pay hikes of only 2-3%, as of June. These increases are very digestible in a high-demand real property investment market.
4. How is the labor shortage impacting commercial real estate?
The June NFIB Survey of Small Business confirms that quality of labor is of more concern to their members than labor cost. In construction, 60% of openings require higher-level skills – a majority of firms in the NFIB survey report “few or no qualified applicants” for needed positions. Higher costs for worker training and extended periods of service-provider shortages will eventually find their way into higher costs. Materials prices are moving up merely because of supply squeezes. Many smaller trade contractors in cities where we are building went out of business last year; the concentration of the larger firms still standing may not be paying that much more for materials, but a booming building market plus little competition is allowing them “take-it-or-leave-it” pricing; in other words, higher costs go to profit, not to measured inflation.
5. Where do you see inflation going in the coming months and in 2022?
In general, we think that the economy has substantial ground to make up before cost pressures force higher interest rates, and history shows that bouts of cost-push inflation prove temporary. Although Bow River believes that bond rates will begin rising again this summer, we don’t see them climbing at the pace many fear. We think ten-year Treasuries will creep up but will not breach 2% this year, still lower than levels stretching back a decade. Bow River does, though, expect core inflation to edge above what the Fed is saying, pushing higher than 3% for the remainder of this year, with only a modest drop back next year.
Rick Pederson is vice chairman and chief strategy officer of Bow River Capital. The firm’s real estate team directs the discretionary investment of more than $625 million in equity across private and opportunity zone funds. Rick is a board member of traded investment vehicles SBH Mutual Funds, ALPS ETF Trust and Principal Real Estate Income Fund and is also a Trustee of the Boettcher Foundation. For more information on Bow River, please visit www.bowrivercapital.com.