Commercial real estate investment is often overlooked as a potential hedge against inflation.
However, it has the advantage of being able to withstand inflationary pressures, as inflation raises the prices of goods and services—including real estate.
In times of higher inflation, commercial property owners can adjust their rental rates to cover the rising expenses. This helps maintain the property's value and protects against a long-term loss of purchasing power.
Inflation refers to the gradual, long-term rise in the prices of goods and services. Several factors influence the annual inflation rate, but interest rates are the most significant.
When the demand for goods and services is high, inflation tends to increase, prompting the government to raise interest rates to control economic growth and moderate price hikes. Monetary authorities aim to manage inflation to a rate of 2%-3% annually, but it can go much higher. This is generally unfavorable for investors.
To ensure that their investments outpace inflation and avoid losing money on a "real" basis, investors need to earn a return more significant than the inflation rate.
For example, a negative real return occurs when an investor makes a return of 2%, but the inflation rate is 5%, causing them to lose 3% of their money's purchasing power. When inflation reaches 5%, 6%, 8%, or even higher, investors must increase their risk appetite to outperform inflation and prevent losing purchasing power.
Regarding CRE investments, rising inflation has several impacts on interest rates, property prices, rents, appreciation, and historical debt.
First, interest and mortgage rates rise as inflation increases, increasing monthly payments for new real estate projects. During the COVID-19 pandemic, for example, interest rates were lowered to stimulate consumer spending. But this ultimately led to inflation reaching a historic high of 9%.
The central bank's response to high inflation was to raise interest rates, which led to higher mortgage rates and monthly payments. As a result, CRE investors may have to opt for lower-priced properties to stay within their budget, reducing demand. Rising inflation also increases property prices, especially in high-demand real estate markets.
While this may lead to capital gains for commercial real estate owners, it may also weaken demand for existing assets, significantly if financing costs have also increased due to inflation.
Yes—a well-managed CRE property can help protect an investor against the ill effects of inflation. Commercial properties are rented out to business tenants that pay rent for the right to use the space. The revenue generated from renting out the property covers the property's operational costs and debt payments.
Any remaining income can be distributed to investors. Expenses increase in an inflationary environment, but property owners can mitigate the impact of rising costs by increasing rent.
The property's income can also be reinvested at higher interest rates to boost overall returns. Rising property prices caused by inflation can also lead to limited property availability, making it harder to sell existing assets and reduce demand. But in the long run, limited availability is likely to drive prices higher, which can ultimately benefit investors.
Commercial real estate assets typically increase in value over time and have historically exceeded the average inflation rate in the US, which was approximately 3.8% between 1960 and 2021.Because inflation affects the prices of all goods—including commercial real estate—it can result in potential long-term capital appreciation.
Although high inflation and interest rates are viewed as negative factors for current debt markets, they can positively impact historical debt, which becomes less burdensome to service as inflation increases.
For example, consider an investor who purchased a retail shopping center for $20 million and took out a $12 million fixed-rate loan with a 10-year term, a 30-year amortization schedule, and a 4% interest rate.
The monthly debt service of $57,200 remains constant for five years, but the value of the investor's money decreases due to inflation over the same period. Thus, each time there is an inflationary period, the relative cost of the debt decreases, making it easier to pay off.
Owning or investing in real estate during high inflation periods can be advantageous. However, it is crucial to remember that markets are unstable, and the advantages may not be uniform across all property types and asset classes.
This is why proper analysis of crucial factors—particularly lease duration, type of debt used, cap rate movement, and structural drivers of supply/demand—can help investors make informed decisions regarding a property's inflation-hedging potential.
For example, hotels can adjust room rates daily, while co-working spaces and self-storage facilities often have month-to-month leases. In the multifamily sector, short-term leases of 12 months are typical, while traditional office, industrial, and retail leases tend to be longer, lasting between 10 to 20 years.Landlords with longer leases with escalation clauses may need help to renegotiate lease terms during unexpected inflation. These clauses permit annual rent increases by a small percentage, which may need to catch up with higher inflation rates.
For example, mortgages with a fixed interest rate throughout the loan period are more stable in the face of fluctuating interest rates than those with floating-rate (variable interest rate) debt. The latter adjusts according to market conditions or a specific reference rate.
Cap rate expansion is accompanied by increased CRE assets' expected risk and return levels. This happens because the asset's value is derived from a lower current valuation or higher projected future cash flows.
Cap rate compression, on the other hand, indicates an increase in the asset's current equity valuation. As a result, lower cap rates are generally more favorable for investors as it may mean that the asset's value has gone up.
Several factors influence cap rates, including inflation, interest rates, rent growth, employment, GDP, and the CRE property’s sector and location. These factors can offset the effect of inflation on cap rates.
For instance, higher interest rates can cause cap rates to expand, but a higher net operating income or a sector experiencing growth trends can counterbalance this effect.
Despite increases in mortgage rates, multifamily cap rates have decreased from 5.2% during the height of the pandemic in Q2 2020 to approximately 4.5% in Q1 2022, primarily due to housing shortages and rising rents.
Similarly, low vacancy rates and high demand for industrial space have caused cap rates in the sector to drop to 3.5% from 6% in Q2 2020. In addition, cap rates are often a byproduct of rising property prices.
As a result, the multifamily and industrial sectors have seen the most significant price gains compared to their counterparts, with increases of 22% and 30%, respectively, as of Q1 2022.
During high inflation, investors must consider risk tolerance and choose investments based on their expected cap rate. Although commercial real estate offers better protection against inflation than stocks and bonds, some properties perform better than others.
For example, privately-owned multifamily apartment buildings had historically performed better than other property types when inflation exceeded 5%, posting returns of 12.71%.
Conversely, the second-best performing property type during such periods was industrial assets, which achieved returns of 11.72%.
For example, the multifamily sector benefited from pandemic-induced cultural shifts in people's lives and work. In contrast, the industrial sector experienced increased demand due to rapid digitization and the widespread adoption of e-commerce.However, regional malls and suburban office buildings face ongoing challenges.
The shift toward hybrid working and reduced consumer spending has decreased occupier demand, higher vacancy rates, and lower revenues. These challenges are further compounded during periods of inflation.
An inflationary environment presents a unique opportunity for CRE investors, as various options exist to generate yields and position existing portfolios for positive returns. All this said timing is everything. For example, when an investor decides to invest in commercial real estate during an inflationary period, prices may increase substantially, making it too expensive.
Therefore, CRE investing should be seen as a long-term hedge against inflation, and investors should consult CRE financing professionals and consider investment strategies early on.
Capital Investors Direct offers financing solutions for commercial real estate investors who need help obtaining funding through traditional banking methods.
Our mission is to provide quick and simple loan products, educate clients on maximizing profits and avoiding risks, and offer convenient and transparent lending services. Talk to us about your CRE project today.
