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Inflation for Fun and Profit

5 min read

Part 1, What to Expect

When sorrows come, they come not single spies, but in battalions. 

Hamlet, Act IV, Scene

Now that the Administration has tacitly acknowledged inflation is a major challenge by blaming it on others, affordable housing allocators, developers, owners, managers and regulators need to readjust their expectations and behaviors. 

Inflation stresses affordable housing more than other residential tenures. Sustainable affordability is a narrow road, and inflation makes it wind, undulate and become foggy ahead.  An industry that for a dozen years got ever more comfortable driving ever faster on a smooth, gently curving freeway now must downshift, smack itself awake, ditch the mental autopilot and pay close attention to the bumps ahead. 

This takes quite some education, based on memory and experience, and that starts with understanding the beasts. Yes, plural, because:

Inflation is like a pack of racing horses. The beasts of inflation—operating costs, people costs, interest rates, market expectations, real estate asset classes, budget deficits, economic strength and more—are jostling animals. Each is ridden by a jockey, each is aware of the others, each wants to outrace the others, and by the nature of their race none of them can fully break free of the others. To understand this herky-jerky stampede, we start with operations, because what happens in operational reality causes delayed effects on financing, underwriting and eventually QAPs and allocations.

Property ‘non-controllable’ expenses jump out first. Utilities, hazard insurance, real estate taxes and security all have cost structures that are themselves vulnerable to exogenous shocks. Owners have to buy these goods and services, have limited flexibility in timing or quantum of consumption, and may have only a few possible vendors – thus owners have next to no leverage contesting the spiked market prices.

Property controllable expenses soon chase after them. Administration and management, maintenance, operations and ownership-related services (legal and accounting) – whether these are people or entities, the same inflationary cost increases that hit multifamily owners also hit these vendors. While the rises tend to be incremental, not sudden, they just keep on coming, especially when employers come under pressure to boost workers’ wages to help them keep up with the rising cost of living.

Property revenue runs a different race, and usually lags behind. Rental income is a clattering chariot that rolls no faster than the slowest of its three horses:

•    Regulatory ceiling. Scattered around the country, little-known government employees produce analyses whose decisions have consequences. Be they the IRS in setting Area Median Incomes (AMIs can also go down, and when that happens, pain ensues), the Department of Housing and Urban Development (HUD) in establishing the Fair Market Rents (FMRs) or setting utility allowances, reviewing Section 8 OCAFs or five-year-reset Rent Comparability Surveys, or HUD and PHAs in reviewing Small-Area FMRs – their results slam lids on revenues for properties they have never seen and do not know.

•    Market ceiling. Because every owner faces similar inflationary pressures, managers need their heads on swivels, especially as the technology of rent optimization has made quantum leaps in recent years, and vendors abound. Affordable owners and managers, who previously didn’t need these tools, now do.

•    Ability to pay ceiling. As a practical rule of thumb, households will pay roughly 60 percent of income for housing and transportation. If forced to pay anything more than that, they cut back on food, health or children’s education. All of these are poverty-perpetuating traps, and people know this, so they try to slide on rent – pay it later, in installments or otherwise scramble. Sometimes they move without warning because they have no choice. The vacancy they leave behind can be costly for the owner to fill.

Combine these balky horses and the results are higher turnover rates, delinquency, collections challenges and leasing concessions. Revenue management during inflation becomes enormously more complex than it was back on the revenue freeway. 

Finally, most of the revenue loss shocks happen immediately, whereas the revenue recovery is delayed by lease expiration, maturation of economic moveout, re-renting (with higher leasing costs and concessions) and new move-in. 

Stress all these revenue elements simultaneously and they loop recursively back into pressuring the operating expenses, especially the controllable ones, because it is human nature to hope things will not be as bad as they really are. 

For government, inflation is not a consumer abstraction, it’s a driver of government cost.

When government is paying subsidies or benefits based on its own inflation measurements, it tends to squish its thumb onto the scales. 

•    Three decades ago, the Bureau of Labor Statistics, the oracles of Consumer Price Index (CPI), quietly changed their measurements, conveniently omitting some non-controllable costs that were then spiking and lowering the rise on CPI, hence saving the government oodles of money. 

•    HUD never sat still for very long on its FMR rules, shifting from 50th to 45th and now to 40th percentile and excluding new apartments that might skew FMRs upward. 

     “Amid all this bad news,” asks the dispirited reader, “is there good news, O Guru?” For the answer, come back next month for Part 2.  

David A. Smith is founder and CEO of the Affordable Housing Institute, a Boston-based global nonprofit consultancy that works around the world (60 countries so far) accelerating affordable housing impact via program design, entity development and financial product innovations. Write him at dsmith@affordablehousinginstitute.org.