Commercial real estate (CRE) is a resilient asset that hedges against ever-rising prices. CRE rental prices will rise in an inflammatory environment, thus increasing property value and net operating value. Inflation is the sustained increase in the prices of goods and services in an economy. It results from a demand for limited goods and services. Currently, the United States inflation rate is projected to trend around 1.90 percent in 2023.
Luckily, real estate possesses many qualities that ensure it maintains and increases in value even when inflation hits. Why? Because it holds intrinsic value – both structure and land are limited in supply despite being a basic need. Today, we take a comprehensive look at three ways to use commercial real estate to hedge against inflation. Read on to diversify your portfolio and gain financial freedom.
Why Hedge Against Inflation
Inflation leads to a reduction in the purchasing power of money. Investors need to protect the value of their investment during periods of inflation. Most investments increase in value during normal economic cycles but decline during inflationary cycles. Investors opt for stable investments that maintain or grow in value during inflation.
Operating costs will increase during inflationary periods. An increased operating cost would mean a reduction in portfolio returns. Investors will either accept reduced portfolio returns or increase prices for their products. It is, therefore, necessary to hedge against inflation to avoid inconsistencies in the value of investments.
Commercial Real Estate as a Hedge to Inflation
As stated earlier, CRE is best positioned to shield investors against inflation. Read on to find out how.
1. Rental Income Increases With Inflation
Inflation leads to an increase in prices. The increase in rental rates is one of the most noticeable effects of inflation. Investors benefit from increased rental rates when operating costs remain relatively constant. Despite inflation, the investor’s net operating income increases.
Nevertheless, tenants are willing to pay higher rents than to take on an unmanageable mortgage. The high demand for rental property prompts landlords to raise their rental rates. Investors who have a fixed-rate mortgage can put this high income toward servicing their debt.
2. Commercial Real Estate Lease Factor
Most commercial real estate leases are structured to include annual rent increases. This protects property owners from the increase in expenses. These increases cause increasing income, which leads to rising values. These increments will benefit investors when they outpace inflation costs.
Investors should structure leases for short-term duration. Short periods allow for adjustments in the rental rates once the lease expires. This will ensure an increase in the short-term yield. Long-term leases with flat rental rates are not positioned well to capitalize on inflation.
3. Property Scarcity
The American population is increasing year after year. Therefore, space for settlement is continually becoming scarce. In addition, the growth of companies will contribute to scarcity. The scarcity of space will increase the requirement for CRE.
Property scarcity often causes prices to increase to outpace inflation. Densely populated regions will establish a high demand for CRE. A region with high demand and a limited supply is an ideal center for real estate. Investors will take advantage of property scarcity to increase rental rates.
How to Invest In Commercial Real Estate
Buying Real Estate Investment Trusts (REIT)
REIT is a mutual fund in real estate assets. In other words, REITs are companies that purchase, manage and finance real estate. Most of these companies specialize in one asset class. They only buy high-quality property. REITs can be publicly traded on major exchanges, registered publicly, or privately. REITs are divided into two main categories:
- Equity: Where investors primarily generate income through rental income from property they own and operate.
- Mortgage: Where investors generate revenue from interest income after purchasing mortgages and mortgage-backed securities.
Net asset value and funds from operation statistics are used to examine the financial position of a REIT. Adjusted funds from operations statistics examine the operation of a REIT. REITs provide investors with a high degree of diversification. Besides, investors owning shares in a REIT do not have to pay corporate tax. All these benefits you enjoy without the hassle of managing them. The downside is you do not have control over investment decisions.
Direct Investment
Direct investment is suitable for investors who have time to manage a property. It also requires a lot of capital to purchase. Investing in this manner requires an understanding of cash flows. Experience in tax implications is also essential.
Direct investments are designed to acquire a controlling interest in an enterprise. It provides capital funding in exchange for equity. Direct investing may involve a company in one country opening its business in a foreign country. Below are the types of direct investments that you should consider:
- Vertical: Investment within a similar supply chain but not in the same industry. A business invests in a foreign company that it may sell or supply to.
- Horizontal: Investment in a foreign country but in the same industry. Meaning a business invests abroad in a company that produces similar goods.
- Conglomerate: Investing in a completely different industry. It cannot be linked to the direct investor in any way.
Direct investment has the highest maximum yield potential. The investor has control over the investment decisions here. However, this will require more active investment involvement. Here is how you can earn money from direct investment:
- Buy to let allows the investor to buy the property and lease it to tenants. It is the most convenient approach.
- Upgrade the property in some way and lease or sell it. Even though this method will require cash upfront, upgrades enhance the profitability of the property.
- Flip it in the short term without making any changes. Investors can complete the transaction and sell the property immediately, netting a quick profit. This method would need to be compared against the profitability of leasing.
Limited Partnerships
A limited partnership is made up of two or more partners. The partnership consists of a general and limited partner. The general partner has unlimited liabilities and oversees the business. Therefore, having full-service investor management software always comes in handy.
The limited partner, on the other hand, has passive involvement with the day-to-day decisions. They have limited liability, which means they can become personally liable if they take an active role. Therefore, you need to find suitable limited partners that share in your vision.
U.S states govern the formation of partnerships under the Uniform Limited Partnership Act. Limited partnerships are registered with the secretary of state. Partnership agreements are created to outline the responsibilities and rights of every partner.
It’s Time to Start Investing in Commercial Real Estate
Inflation is an inevitable situation in the economy. The current economic patterns are irregular, making the prediction of inflation periods difficult. To navigate its effects, investors need to understand the mechanisms of this phenomenon. At EXtrance, we can help you unlock the potential of commercial real estate investment. Ensure you contact us today to learn more.