The Specter of Deflation and What it Means for GSA Lessors

One well-known quirk of GSA leases is that operating cost reimbursements are not based on increases in actual costs. Rather, they are calculated on the increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), one of two primary CPI indexes published monthly by the Bureau of Labor Statistics. For each lease, an Operating Cost Base is established, and GSA pays the Lessor additional rent each year based on the growth in the CPI-W index.

Suppose, for example, that the Operating Cost Base is established in the lease as $10.00 per rentable square foot and the CPI-W index at the commencement of the lease is 200 (GSA evaluates index changes using data from the month before the commencement of the lease). If the index grows from 200 to 204 over the ensuing lease year, that’s a 2% increase. Based on this index growth, GSA would provide the lessor with an “Operating Costs Adjustment” of $0.20 per rentable square foot (2% x $10.00).

Note that I’ve been using the terms “growth” and “increase” to describe changes in CPI-W. Most other people do that too; assuming increases is an easy trap to fall into because the CPI-W index generally grows year-to-year. In fact, U.S. monetary policy is founded on the goal of generating modest inflation to provide a slight buffer against deflationary forces. In an effort at transparency, the Federal Reserve announced a 2% goal for long-run annual inflation nearly a decade ago. Yet, sometimes when shocks occur, like the current pandemic, the economy is pushed towards deflation despite countervailing monetary and fiscal policy. And that is what is occurring right now.

Compared with the end of 2019, the CPI-W index has fallen this spring by almost 1% (measured as the difference between the 250.452 index recorded for December 2019 and 249.515 recorded in April. The decline is modest and the year-over-year index remains positive at 0.07%, but it is drawing perilously close to deflation when GSA rents would decrease.

There have only been two periods of negative year-over-year CPI-W in the past 65 years, both in recent memory, as shown in the graph below. The most recent instance was when CPI-W dipped almost to negative 1% in 2015. Several years earlier, CPI-W shrank further, down to negative 2.7% year over year in July 2009, as the Great Recession ended. On both occasions, these deflationary periods lasted almost a full year and GSA rents declined as a result. Before these two periods, we’d need to travel back to the mid-1950s to experience deflation.

Source: Bureau of Labor Statistics, CPI-W Index (1982-1984=100)

Though most economic indicators are currently ominous, economists can’t agree on where the economy is ultimately headed. Some believe deflation is inevitable, especially as demand is collapsing due to sharply increasing levels of unemployment. Others note that unprecedented levels of monetary and fiscal stimulus flowing into the economy could have the opposite effect of hyperinflation. The Fed has cut the target range for the federal funds rate by a total of 150 basis points to its current range of 0 to 25 basis points. It has purchased more than $2 trillion of U.S. Treasuries and mortgage-backed securities and engaged its emergency lending powers to implement a wide array of loan programs to support households and businesses. On top of that has been the fiscal stimulus, via the CARES Act and related measures, that have pumped a further $2.3 trillion into the economy in both direct payments and tax relief. Further fiscal and monetary stimulus seems inevitable.

It’s beyond the scope of this article to opine on which view is correct in the deflation versus inflation debate. Yet, the immediate economic threat is deflation. Over the longer-term, the range of potential inflationary and deflationary economic outcomes is amplified. The unpredictability of all of this will make asset and property management particularly challenging through the remainder of this year and likely through 2021. This will be true for all real estate sectors, but especially for GSA-leased assets. GSA lessors will face particular concerns since actual expenses incurred are decoupled from the reimbursements GSA tenants pay; the factors driving building operating costs differ from the basket of goods used to measure changes in inflation. For a time, the oft-ignored CPI-W index becomes one worth closely monitoring.

Want Capitol Markets articles delivered straight to your inbox?