Chart – Inflation Watch as 2025 Begins: TIPS Spead Indicating 2.44% Expected Inflation for Next 5 Years

The chart above is of the 5-Year breakeven inflation rate, commonly referred to as the TIPS spread, for the five year period ending on January 7, 2025. This illustrates the difference in the yields, i.e. the spread, between United States Treasury bonds and Treasury Inflation-Protected Securities (TIPS) of the same maturity. This is a useful and frequently quoted measure of expectations for (CPI) inflation in the financial markets. The spread indicates expected inflation, of interest to investors in commercial real estate – read more about that below – and for that matter investors of all kinds, not to mention consumers.

The 5-year TIPS spread hit a high in March, 2022 at 3.59%. As the Fed has maneuvered aggressively to tap inflation down, this pulled back to around 2.5% that same year, where it has remained since. Actual inflation was of course much higher at times, but the expectation for the coming 5 years remained more subdued as monetary policy resolutely addressed it.

It’s worth noting that despite concerns raised by some about potential inflation risks from the incoming administration’s stated plans, the markets don’t appear to be signaling alarm—at least for now. The uptick that began in September 2024 could reflect these concerns as the election outcome became more certain. However, it seems more plausible that this movement is simply what it appears to be: a minor fluctuation in the TIPS spread within the range it has occupied since late Q3 2022. Market participants seem to be betting that either the proposed policies won’t be implemented at levels that would drive significant inflation, or that these policies are less inflationary than some have suggested.

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

~Sam Ewing

Real Money on the Line

Real money is at stake with these spreads. TIPS pay interest every six months, based on a fixed rate that is calculated by multiplying the adjusted principal by one-half the calculated interest rate (i.e. half a year’s worth of inflation at that rate). Thus, a “bet” that an investor makes with these bonds has real financial implications. If actual inflation is higher than priced in the markets, a TIPS buyer will make more that a straight treasury buyer. If it is lower, that TIPS buyer will make less. How much money is at stake? In 2017 Morningstar pegged the market at $1.2 trillion. Thus, every 1% difference is a $12 billion swing. Real money.

Also seemingly relevant to the topic of effectiveness of this spread to predict inflation is a research piece put out by the Bureau of Labor Statistics in 2019: Inflation expectations and inflation realities: a comparison of the Treasury Breakeven Inflation curve and the Consumer Price Index before, during, and after the Great Recession. It concluded that TBI (Treasury Breakeven Inflation) rates reasonably approximated inflation reality before, during, and after the Great Recession of 2007-2009.  It noted that the average and median deviations between TBI rates and their respective annualized CPI-U inflation rates never exceed 81 basis points, and that, moreover, the dispersion of deviations, as measured by standard deviation and range, decreased as the maturity horizon increased. It went further to speculate that given that TBI expectations overshoot actual inflation in the long term and undershoot inflation in the short term, it is likely that the liquidity premium has a considerable effect in the short term but gets more than offset by the inflation premium in the long term.

Generally on Inflation and Commercial Real Estate

What is the impact of inflation on commercial real estate? In the near term, higher inflation tends to bring higher interest rates. Higher interest rates are a negative for commercial real estate. Higher rates means larger debt service payments, reducing the buying power of purchasers, and negatively impacting deal economics. It also means makes fixed income investments a more competitive investment, likely pulling capitalization rates (cap rates) up, and thus prices down. Over a longer period, however, the prospect of inflation leads to a principal benefit of commercial property investment, that of its potential as a hedge against inflation. After all, more inflation should lead to higher rent, at least in time.

In the near term, higher inflation typically leads to higher interest rates, which are generally a negative for commercial real estate. Higher rates result in larger debt service payments, reducing the buying power of purchasers and negatively impacting deal economics. Additionally, as fixed-income investments become more competitive, capitalization rates (cap rates) tend to rise, driving property prices downward. This can create challenges for sellers and lead to reduced transaction volumes as buyers adjust their return expectations.

Over the longer term, however, inflation can highlight one of the principal benefits of commercial real estate investment: its potential as a hedge against inflation. As inflation rises, rents generally increase, especially for properties with shorter lease terms or those tied to CPI-based escalations. These higher rents can drive income growth, offsetting some of the negative effects of inflation on property values and financing costs.

Effects on Income

Inflation often benefits property owners by increasing rental income over time. This is particularly true for properties with leases that include annual escalations or that allow for renegotiation at market rates. However, the timing of income growth can lag behind inflation, especially in markets with long-term leases or significant rent control measures. For properties with operating expenses passed through to tenants, rising costs may be recouped, preserving net operating income (NOI).

Effects on Pricing

Higher interest rates driven by inflation exert downward pressure on property values as cap rates rise. Investors may require higher yields to justify their investments, which compresses pricing, particularly for stabilized assets. However, assets with strong income growth potential or located in high-demand markets may still attract premium pricing. Inflation may also drive the cost of new construction higher, potentially reducing supply growth and supporting pricing for existing properties.

Effects on IRR for Investors

Inflation’s impact on internal rate of return (IRR) is multifaceted. In the short term, higher interest rates and rising cap rates can erode IRR due to increased financing costs and lower exit values. However, over the long term, properties with strong income growth can recover and even enhance IRR as rents and NOI rise. The timing and extent of these effects depend on the asset type, market conditions, and lease structures. Properties in sectors with shorter lease durations (e.g., multifamily or hospitality) may see faster rent adjustments, boosting IRR more quickly than those with long-term leases.

Summarizing the Effect of Inflation on Commercial Real Estate

While inflation presents short-term challenges for commercial real estate by increasing borrowing costs and pressuring valuations, it can create long-term opportunities for investors to benefit from rising rental income and its role as an inflation hedge. To mitigate risks, investors should focus on assets with strong income growth potential, favorable lease structures, and markets with resilient demand.

MIT published an excellent whitepaper on real estate’s ability to keep pace with inflation with data to 2016. They looked at then tendency of retail, multifamily, industrial, and office income and values to keep pace with inflation. The best at keeping pace income-wise was retail, with rent growth of 102% of inflation. Office was the worst performing at a quite dismal 18%. Values across the property types were more consistently kept pace, with retail again doing the best appreciating at 107% of inflation, office again the worst at 74% of inflation. I’ll speculate that the fairly drastic difference between income and value keeping pace with inflation is driven by vacancy. If you’re interested in the topic, read the paper.

Expectations for inflation come into play with lease structure and due diligence. A lease with a fixed rent increase becomes less attractive for a landlord with higher inflation expectations, and or course more attractive for a tenant. Similarly, a commercial property that is being acquired with existing leasing in place that have fixed or capped rent increases looks less attractive as inflation expectations increase. Also, a property being purchased with fixed rate financing will look increasingly attractive if a buyer anticipates inflation fueled increases in income. Finally, higher inflation tends to bring higher interest rates, which have a huge effect on commercial real estate. Inflation, in short, is very important to commercial property investors.

Resources Related to this TIPS Spread Post:

• WSJ US Treasury Quotes
• WSJ US Treasury Inflation-Protected Notes
• JP Morgan: Reading Inflation Expectations from the Treasury Market
• Investopedia: The Tips Spread
• US Bureau of Labor Statistics Consumer Price Index (CPI) Page
• Kansas City Fed: Can TIPS Help Identify LongTerm Inflation Expectations?
• Reddit Question: How can inflation expectations be deduced from the market?
• Considering Cap Rates and Potential Effects on Values as the Interest Rate Environment Changes

Citation for Chart: Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIE, January 8, 2025.