Will Inflation Metrics Change?

The Real Estate Espresso Podcast

Will Inflation Metrics Change?

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Will Inflation Metrics Change?

Shock Show Manager, welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce.

Today we are going to be talking about something that on the surface sounds technical, maybe even academic. But first, today’s show is sponsored by Cost Segregation Guys. If you own investment real estate and haven’t looked seriously at cost segregation, you could be leaving significant tax savings on the table. Cost Segregation Guys help investors accelerate depreciation, improve near-term cash flow, and make more efficient use of capital, all without changing the underlying asset. To learn more, click on the link in the show notes and you’ll be connected directly with them and qualify for a discount because you came from the show. Check out the Cost Segregation Guys.

On today’s show we are talking about something that is maybe a little technical but definitely not academic. We’re talking about proposed changes to how inflation is calculated and what that could mean under the new Fed Chairman, Kevin Warsh.

Now, before we get into the implications, let’s start with a simple premise. And by the way, administrations over the years have tweaked the definition of inflation, usually to make adjustments that make the number a little bit smaller. That’s beneficial for politicians because it creates the illusion that inflation is running lower than it really is. So we need to understand the premise. If you change how you measure something, you often change the outcome, and if you change the outcome, you change the decisions that follow. And that’s exactly what’s at stake here.

It’s no secret that the White House is looking for the Federal Reserve to lower interest rates. If this plays out the way it looks like it might, the President will not get his wish.

See, the problem with the inflation measurement is that the Fed looks at inflation through the Personal Consumption Expenditures Index, or what’s called PCE. They also pay attention to something called Core PCE. Both of these measurements have limitations. They rely heavily on statistical adjustments: hedonic adjustments, substitution effects, owner’s equivalent rent. These are not trivial adjustments. They are structural assumptions baked into the data.

For example, if steak becomes too expensive and consumers switch to chicken, the index assumes the substitution and dampens the measured inflation. But here’s the problem. From a lived-experience standpoint, people don’t feel like inflation has gone down; they feel like their standard of living has declined, which in fact it has. That disconnect between reported inflation and experienced inflation is one of the biggest credibility challenges facing the central bank today.

This is where someone like Kevin Warsh could represent a shift. He’s not a typical central banker – he comes from a market-oriented background with time spent at Morgan Stanley and was a Federal Reserve Governor during the financial crisis. He’s been openly critical of the Fed’s communications strategy and, more importantly, its measurement frameworks.

Warsh has argued that central banks risk losing credibility when their metrics don’t align with the reality as experienced by households and businesses. So let’s translate that into inflation measurement. If a Warsh-led Fed were to move forward to a more common-sense measure of inflation – less adjusted, less modeled, and more observable – you’ll end up with a systemically higher reported number. Not because inflation suddenly increased, but because the measurement changed.

This is why it matters for interest rates. The Fed sets monetary policy based on its inflation targets of roughly 2%, and if inflation is measured higher, then by definition, the Fed is further from the target. That creates pressure for tighter monetary policy. Higher inflation readings could justify higher interest rates, slower rate cuts, and a more hawkish stance overall.

Markets don’t wait for policy, they anticipate it. So even the expectation of a change in the inflation measurement could push bond yields higher. And as we’ve discussed on this show many times, real estate is a spread business, and by that I mean the spread between interest rates and the yield on cost of your investment, or the cap rate.

So let’s connect the dots. If inflation is measured higher, interest rates could stay higher for longer, and cap rates might be going up to adjust, not instantly, but directionally over time.

Now, we’ve already seen what happens when the risk-free rate rises. Asset values compress, but there’s a second-order effect that’s just as important. Higher measured inflation could also support higher nominal rent growth. So you get this push–pull dynamic — on the one side, interest rates compressing. It reduces valuations. On the other hand, higher nominal income supports more cash flow. So the question is, which force is going to dominate?

The answer could depend on the asset class. For example, multifamily in a supply-constrained market tends to reprice rents relatively quickly. That provides some hedge against inflation. Industrial properties with shorter lease durations also behave similarly. But office and long-term lease retail, well that’s a different story. They’re locked into 10- and 15-year leases with fixed escalations of 2% a year. And if actual inflation is running at 4% to 5%, your real income is declining.

So a shift in inflation measurement doesn’t just affect cap rates, it affects asset performance.

There’s another layer to this. Institutional capital allocates based on real returns, not nominal returns. So if reported inflation increases, then real estate returns decline unless nominal returns adjust upward. That means investors will demand higher yield across the board. And in real estate, that translates into higher cap rate expectations, maybe more conservative underwriting, and maybe just less capital available in the real estate segment. It’s not theoretical, it’s just how capital reprices risk.

But then maybe the most important dimension is credibility. We’ve seen that real estate inflation has been systemically understated, and that if the new framework is more honest, then expectations could become unanchored. Inflation expectations are a powerful force, and once they move, they are very difficult to bring back. And so that is when you get into a regime shift, not just a cyclical adjustment.

So what should you do as an investor? Well, first of all, you want to be paying attention, that these measurements matter. Don’t anchor your strategy to a single inflation metric. Next, you want to look at multiple indicators – the Consumer Price Index, PCE, wage growth, commodity prices.

And then, second, you want to stress test your deals. What happens if interest rates stay 100 basis points higher than you expected? What happens if rent growth tracks inflation more closely? In an environment when inflation is both higher and more visible, the ability to reset income becomes one of the most valuable attributes in a real estate investment.

At the end of the day, a change in the inflation measurement doesn’t change the underlying economy, but it does change the lens through which policymakers and lenders and investors interpret reality. And in many markets, that perception often becomes reality.

As you think about that, have an awesome rest of your day! Go make some great things happen, and we’ll talk to you again tomorrow!

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