The business buzzword for 2022 is: Inflation.
The inflation rate in 2021 was 7.5%, a rate that the the Federal Reserve says took them completely by surprise. And 2022? Many prognosticators (this author included) believe inflation will hit double digits for the first time in more than 30 years. This comes after rates of inflation consistently at or below 2% for the past decade. As a result, many marketplace participants simply are not aware of strategies that will enable them to navigate the shoals of an inflationary environment.
This blog entry may pivot between references to rates of inflation and rates of interest for borrowing. These two concepts, while different, are addressed interchangeably as (a) inflation is a widely accepted indicator of an over-stimulated economy and (b) the predictable response to inflation is raising interest rates charged to banks by the Fed to dampen that economic activity. In turn, banks will then raise the rates charged to consumer and commercial borrowers. So, higher inflation inevitably begets higher interest rates. The Fed has forecasted both (i) the possibility of front-loaded rate increases, meaning sharp rises in the coming months (as opposed to sequential rate hikes being stretched out over months and years) and (ii) as many as seven rate hikes in 2022 alone. This means interest rates could rise by a full 2% or more from today’s rates before January of 2023. How high can rates go? In March of 1980 the prime rate of interest peaked at 19.5%. Imagine the impact of interest rate adjustments on your business model at those exorbitant rates.
Here are a few things to consider to protect yourself in inflationary times:
- Utilize commercial rent adjustments to your advantage. During low inflationary times, landlords and tenants have commonly avoided complex periodic calculations for rent increases based upon Consumer Price Increases (CPI) increases, in favor of either fixed rent rates during the term of a lease or rent increases only pursuant to a fixed schedule (say, for example 5% increases every 3 years). As inflation accelerates and persists at high levels, landlords will hope they had full CPI adjustments built into their leases past and will start demanding then in leases in the future. Conversely, tenants will cherish fixed-rate, longer-term leases that create a benefit to them of inflation (but the rapidly-changing office and retail markets might cause devaluation of spaces that previous saw decades of stability and strength). As always, we recommend that tenants consider asking for an early termination provision in all commercial leases.
- Anticipate and avoid mortgage interest rate surprises. Many residential mortgages and most commercial mortgages have fixed interest rates only for a few years. As to residential rates, after the period of the fixed rate, frequently rate increases are capped, but will still be painful. But for commercial borrowers, when the fixed term expires, the rate increase is typically unlimited. As a result, commercial borrowers locked into mortgages that might not be paid off for a decade or more could have dramatic, uncapped and unanticipated increases in the interest portion of the mortgage payment that continues to escalate each adjustment period. To mitigate these impacts, consider refinancing into a new fixed-rate term that gives you breathing room before the impact of higher rates hits with full force. Also, the sale of parts of your portfolio to pay down debt could lift your P&L from the greatest impacts of interest rate hikes.
- Be careful of fixed-rate pricing. Home builders, contractors and manufacturers are experiencing difficulties fulfilling obligations under fixed-price contracts for matters that have a delivery date well into the future, shrinking their profit margins or turning winning contracts into losers. Our office then is seeing instances of home builders trying to walk away from contracts and contractors seeking to convert fixed-price contracts into cost-plus agreements, shifting material and subcontractor pricing increases to buyers. If you are that builder or contractor, consider adding an automatic or negotiated inflation adjustment in the contract and as a buyer, you want to lock in that fixed pricing firmly.
- Anticipate suppliers walking away from contracts. Similarly, we have seen manufacturers and distributors of certain products avoiding their obligations to supply certain goods or equipment. As a buyer, do you have your supply contracts documented correctly and have you diversified your supply pipeline to protect yourself if a supplier lets you down? Is the party with whom you are contracting sufficiently capitalized to stand behind their contractual obligations?
- Consider inflation and interest-rate contingencies. The Cincinnati Area Board of Realtors/Dayton Area Board of Realtors form residential purchase contract allows a buyer to state the specific terms of the mortgage it is seeking as a contingency to ia buyer’s performance under the contract. If you specify a “fixed rate loan for 80% of the purchase price at a rate below 3.5% per annum fixed for a period of 30 years,” and interest rates rise before the closing, the buyer has a perfect out. Similarly, buyers and sellers can include in any contract an “out” for high rates of inflation and higher interest rates.
- Be wary of options. Options to renew leases and options to purchase may seem innocuous and predictable in stable times. But in a dynamic high-interest rate marketplace, an option acquired today to buy a property at a fixed price three, five or ten years into the future (say under a long-term commercial lease) can unexpectedly enrich the option holder. Options can be a way a way to leverage dramatic profits to the option holder.
- Be prepared to offer seller financing. A close partner to higher interest rates are tighter lending standards. Fewer and fewer buyers can afford to buy at inflated interest rates, and lenders also frequently tighten their loan eligibility standards. As a result, a eligible buyers — abundant today — become frighteningly scarce. In the worst of the inflationary period at the end of 1977 to 1981, sellers had to offer loan assumptions, land contracts, leases with options (or obligations) to purchase (with the warning noted above) and simple notes with accompanying mortgages to get any property sold.
- Be prepared to buy at foreclosure sales. Foreclosure sales, which have virtually disappeared for the past two years, could come roaring back as commercial and residential owners cannot afford their new, higher mortgage payments, and, of course, mortgage foreclosure moratoria have been lifted.
- Be prepared to offer seller financing. A close partner to higher interest rates are frequently tighter lending standards. Fewer and fewer buyers can afford to buy at inflated interest rates, and lenders also frequently tighten their loan eligibility standards. As a result, a eligible buyers — abundant today — become frighteningly scarce. When lending is loose (as today), it seems readily available to anyone. And when it tightens, it seems to strangle the marketplaces. In the worst of the inflationary period at the end of 1977 to 1981, sellers had to offer loan assumptions, land contracts, leases with options (or obligations) to purchase and simple notes with accompanying mortgages to get almost any property sold.
We saw with the rapid deterioration of the real estate market from 2006 to 2010 that buyers many times would willfully breach their contractual obligations to buy or rent. In this process, they would search for a contingency or loophole — any argument whatsoever — to evade their contractual promises. And in other instances, they would just outright walk away. Accompanying these contractual breaches were also insolvency and bankruptcy, making collection impractical or impossible. Similarly, as the real estate marketplace has heated up over the past five years, we have seen sellers work to evade their contractual obligations so they could retain an appreciating investment or simply realize a higher price from a second buyer.
How can you protect yourself in this type of dynamic market to assure performance by a buyer or seller?
- Consider escrow deposits, guarantees and other security. Sellers can demand higher earnest money deposits, non-refundable deposits and short contingency periods. Buyers can use tools we have written about here and here of Affidavits of Facts Relating to Title and legal actions for specific performance. Further, consider adding personal guarantees to contractual promises from corporate and LLC buyers or sellers. Additionally, the performance by buyers and sellers can be further secured with mortgages against real property and secured positions in other assets.
- Add an attorneys fee provision. Also, consider adding a contract provision shifting the expense of attorneys fees to the breaching party in a contract. That can sometimes change the calculus of a prospective breaching party.
- Tighten your contract language. To lock buyers and sellers into real estate and supply contracts and leases, carefully consider ways the other party might find a contingency or loophole in their performance. Contingencies (commonly for inspection or financing) are the tunnel through which most buyers drive to walk away from a contract. Ohio law provides that a buyer must “reasonably” attempt to fulfill a contract contingency, but many still attempt to use contingencies to artificially and intentionally avoid their legal obligations. Fraud on the part of a seller (such as an undisclosed material defect discovered before closing) can also arguably be the basis for a buyer not performing. Conversely, typically there are no contingencies to a seller’s performance under a contract. But consider everything in the instrument — the date, the property description, the parties’ names, the “acceptance” language and timing, in considering how the other party might try to squirm away from their promises.
As the economy becomes more unpredictable and more dynamic in terms of pricing, supply shortages and interest rates, market participants would be wise to carefully think about the impact of inflation and interest rate hikes on their contractual obligations and market positioning.