When examining the relationship between inflation and commercial real estate (CRE), it is essential to understand how it affects everyone involved in the investment.
There have been multiple interest rate hikes this year imposed by the Federal Reserve that were higher than usual in an attempt to control the inflation rate.
There have been eye-opening highs and lows throughout the year regarding what veteran investors refer to as classic bear market rallies, which have investors leaning on commercial real estate as a hedge against inflation.
CRE allows for a steady cash flow over the years, including changing lease terms that owners may be able to adjust to a fluctuating CPI. It’s all about making an informed decision based on multiple factors, including the type of CRE, the sector, and more.
What Is Inflation?
Inflation typically represents how purchasing power has declined. It measures the price increase for goods and services over a period.
Each year a rise in cost of two percent or less is beneficial because it may boost supply, increase production and encourage higher demand. These factors keep a healthy level of competition within the economy.
However, you can’t have excessive inflation without a proportional wage increase. The inflation rates we’ve seen recently haven’t been this high since the 1980s.
The BLS reports that the CPI (Consumer Price Index) was up 8.3 percent this past August over the previous year. That totaled 16 successive months when the country experienced an inflation rate of at least five percent or more.
With so much uncertainty and volatility in the markets worldwide, 2022 has been a tricky year for investors. When the economy entered tumult because of the interest rate hikes, inflation and commercial real estate concerns became more pressing in investors’ minds.
Currently, inflation has risen to such high levels because of the elevated demand for goods and services coupled with mass labor and supply shortages within the economy.
Ideally, investors wanting to combat inflation would select assets that appreciate over time or maintain their value.
If you want to choose the best option for securing your assets, at EXtrance we offer the best options to manage your investments in times of instability.
How Does Inflation Affect Commercial Real Estate?
For starters, the type of inflation is a determining factor. When inflation occurs because of sustained economic growth, it positively impacts CRE. Inflation results from stagnant demand and persistent unemployment, which spells trouble for investors.
Commercial real estate is a tangible asset that usually increases in value commensurate with inflation. It’s not a guarantee, but it has been proven over the years.
Like other tangible assets, commercial real estate (CRE) tends to appreciate in value proportional to inflation. This is proven, although not a constant guarantee.
A study from the National Association of Real Estate Investment Trusts concluded that the dividend increase for REITs outperformed in 18 years of the last two decades.
Here are the two ways inflation and commercial real estate are connected; we’ll extrapolate later to demonstrate which participants get hit the hardest by these factors.
Supply and Demand
As the standard costs to produce and purchase continue to rise, it is more challenging for developers. Additionally, labor costs have increased so new construction may occur less often, and real estate assets might not be as readily available.
Therefore, development projects seem riskier, deterring investors from purchasing. They need help remaining stable during labor shortages, pricing, permitting, timelines, and supply chain problems.
Anytime a new construction project ceases for any reason, the current inventory value rises, especially if that property type experiences high demand.
Multifamily and industrial real estate saw a dramatic increase in cap rate and appreciation with higher demand in 2021.
Operational costs such as insurance, utilities, and maintenance also suffer when inflation increases. The cash flow can decline when owners have to pay more for upkeep on a property.
Investor returns and future cash flows are also in jeopardy when the dollar’s power starts plummeting. For example, based on inflation, one dollar can be the equivalent of 0.70, 0.90, or 0.80.
On the other hand, property owners that can boost their NOI when the dollar starts declining can raise rent prices to help protect their returns and the actual value of their cash flow.
Certain asset types are quickly pushed to the forefront of the market, like CRE, because it’s viewed as an inflation-resilient investment that will help mitigate the effects.
If you are worried about your investment and want to maximize your security in assets, Entrance has several options.
Inflation and Commercial Real Estate Asset Type
With CRE, there are different protections against inflation across every sector. For instance, industrial real estate and apartment buildings recorded the greatest returns in private real estate.
At one point, retail used to be an effective option against inflation because of the way that shorter-term leases function. However, the emergence of COVID-19 caused more retail to move online, causing the market to change.
Private vs. Public CRE Liquidity
Inflation tends to hurt public REITs and help private CRE—similar to the effect of stock returns. The other factor to include in these cases is liquidity.
Private CRE typically has low liquidity, and because of this, it is better protected from inflation and an economic crisis. On the other hand, public REITs are generally more liquid and, therefore, more likely to yield a better return when the market is booming.
One must also consider the operational costs on property value as a significant factor. Some people can transfer these costs; however, some owners need help to do so. Additionally, labor costs will affect particular kinds of properties more than others, such as hotels.
In the world of CRE, resilience during inflation varies according to the asset class. It is mainly contingent on how frequently and quickly the CRE owner can adjust the rent payments.
Thanks to the nature of leases, especially if they are shorter, the owner should be able to alter the rent in relation to inflation. Usually, multifamily, self-storage, and hospitality establishments have short lease terms.
Contrastly, a triple net lease indicates that the real estate asset has a long-term lease with built-in rental rate increases, which locks the agreement into a more rigid schedule.
Therefore, there will be no room to increase net operating income to offset the effects of inflation.
An example of a triple net lease is a retailer like Walgreens or Starbucks or an industrial-type lease to one tenant like Amazon who might have a deal that covered two to three decades.
Inflation and CRE Participants
The effects of inflation on CRE are not the same for developers, buyers, tenants, and brokers. This group will endure the rising cost of goods, higher interest rates, and fewer available units.
Since interest rates are rising, some buyers may get priced out of the market or have to deal with less beneficial leveraging financing; however, this will primarily depend on whether they work in the private or public sector and the impact of liquidity.
Developers face different problems; rising interest rates, the price of construction materials, labor shortages, and scarcity due to supply chain issues make doing some projects impractical. As a consequence, the previously developed space has an upward value pressure placed on it.
However, some specific locations and sectors constrain the supply of previously developed properties in conjunction with high demand, letting projects continue to make money.
Owners with existing developed properties will benefit from having locked-in interest rates that were historically low. In these cases, the property cost will stay the same; however, the property value will appreciate.
In most instances, owners will enjoy the fruits of lower supply and higher demand.
Some owners might have the opportunity to transfer some of the operational costs to their tenants, which is beneficial for shorter-term or leases that adjust to CPI.
Individuals who own CRE will likely benefit from having previously locked in a lower interest rate, as renovation and refinancing will taper off in the months ahead.
Leased properties will have more attractive tenant lease agreements because of the lower operational costs, allowing them to maintain occupancy easier.
Since there is uncertainty concerning future expenses and revenues, they are more likely to sign longer-term leases to secure lower fixed-rate increases in the future.
Tenants are likely to have similar benefits as owners of the existing developed properties. In retail sales, tenants may look for flexible leases which fit their revenues, flexibility that benefits both the landlord and the tenant.
Understand the Impact of Inflation on CRE Today
Time is of the essence because CRE, as an inflation hedge, works better strategically over the long-term such as five to seven years or more. Since it’s a short-term investment tool, it cannot provide immediate protection within a more significant investment portfolio.
CRE are susceptible to increases in operating expenses and inflation shocks that may not be able to be recouped in rent increases or passed off to the tenant.
By entrusting your investment management to a reputable company like EXtrance, you can rest assured we’re making informed decisions regarding inflation and commercial real estate.
Contact EXtrance today to learn how we can help you maximize your commercial real estate investments.