How does inflation impact commercial real estate? Commercial real estate is frequently acknowledged as a robust strategy for countering inflation in the long run. Also, commercial real estate isn't entirely immune to inflation. But, its track record showcases strong performance during periods of above-average inflation. This is due to its capacity to generate and enhance income returns for investors, often through leases linked to inflation metrics. This article aims to understand the correlation between inflation and commercial real estate.
If you're seeking the most secure investment option amid inflation, consider commercial real estate. Wondering how to venture into this sector? While there are numerous avenues, the standout choice is structured debt in commercial real estate. Why? The steady income generated from fixed-interest payments forms the foundation of debt investments. Borrowers consistently make their payments regardless of market variations, contributing to the stability and preservation of investment value.
What is Inflation?
Inflation entails the gradual, extended escalation of goods and services prices over time. Consider the journey of a non-real estate product, such as Coca-Cola's pricing history. Between 1886 and 1959, a 6.5-ounce can of Coca-Cola was priced at a mere 5 cents. However, the subsequent decades witnessed a steady climb, culminating in the current cost of approximately $1.19.
Image: Inflation is currently at its highest level in nearly four decades, as indicated by the Year-Over-Year percentage change in the Consumer Price Index (CPI) for all urban consumers.
Current Inflation Rate
In August 10, 2023, the U.S. Bureau of Labor Statistics released its latest report indicating that the annual inflation rate has reached 3.2%, marking a slight increase from the previous month's rate of 3.0%.
The current inflation in the United States is primarily attributed to the continued presence of supply disruptions and shortages in the food sector, which initially originated during the pandemic. Alongside this, elevated energy prices are also contributing to inflationary pressures. It's important to note that inflation is not solely a consequence of anticipated economic shifts, but it is also influenced by geopolitical occurrences that send ripples through the economy. Notable events like the COVID-19 pandemic and Russia's incursion into Ukraine exemplify how unforeseen global developments can impact inflation dynamics.
Over the extended term, it's customary to observe mild to moderate inflation, which coincides with the appreciation of both investment assets and the cost of goods and services. Nevertheless, a period characterized by elevated inflation tends to exert adverse effects on various investments like stocks and bonds. But, this scenario can yield favorable outcomes for specific investments like commercial real estate properties.
Let us see how commercial real estate responds during inflation.
How Does Inflation Affect Commercial Real Estate?
1. Favorable returns
Starting from 1978, private equity real estate delivered an annual total return of 9.2%, accompanied by a 7% income return, as can be seen in the image below. These consistent and favorable income returns are partly attributed to landlords' capacity to frequently adjust rents in the case of short-term leases, such as apartments, and to incorporate escalator clauses in longer-term leases, such as those in the industrial sector, to navigate periods of unforeseen inflation. Adding an appreciation rate of 2.2%, the cumulative performance of commercial real estate has surpassed inflation (which has averaged 3.5% over the same period) by a substantial 570 basis points on an annual average basis.
Image: Since its inception in Q1 1978, the NCREIF Property Index has consistently delivered returns that surpass inflation rates.
2. Escalating Labor and Material Costs Foster Limited Supply
Rising production costs make new projects expensive. This leads to fewer available buildings at lower costs compared to new construction estimates. This causes rental rates and property values to rise. Many commercial real estate leases include yearly rent increases. This protects property owners from rising costs due to inflation. Therefore, existing commercial real estate becomes a strong defense against inflation.
3. Rising Property Valuations
As consumer goods prices rise, the impact reaches tangible assets like real estate. This is especially evident in strong real estate markets with high demand. For owners of commercial real estate during inflation, these price increases can lead to significant gains. However, it's important to note that as property prices soar, demand for existing assets can decrease, especially when financing costs rise with inflation.
4. Income Generation
Commercial real estate properties are tenanted by businesses, which, in exchange for occupancy, offer rental payments. This rental income caters to operating expenses and debt service for the property, leaving residual proceeds for distribution to investors. In an inflationary ecosystem, expenses rise, yet the silver lining is that commercial real estate property owners can counterbalance the impact of escalating costs by augmenting rental rates. Furthermore, surplus income can be reinvested at more lucrative interest rates, consequently bolstering overall returns.
5. Constrained Property Supply
Rising property prices can reduce demand for commercial real estate due to higher financing costs. This makes it harder to sell existing assets. The basic rules of supply and demand suggest that when commercial real estate properties are scarce, prices tend to go up, which is good for long-term investors.
6. Rent Upticks
Numerous commercial real estate leases integrate "rental escalation clauses," stipulating periodic rent hikes. This duality encapsulates both positive and negative implications for real estate investors. On one hand, such clauses empower commercial real estate owners to enhance rental income, thereby bolstering property revenue. However, it's pertinent to note that commercial lease terms often span 5-15 years or longer. In an environment marked by substantial inflation, annual rent increases of 2% or 3% may prove inadequate to keep pace, and the extended lease duration might necessitate considerable patience for a rental market reset.
7. Appreciation of Assets
Over time, most commercial real estate assets appreciated, historically surpassing the United States' average inflation rate of approximately 3.8% from 1960 to 2021. In essence, inflation's pervasive effect on prices extends to commercial real estate, culminating in noteworthy capital appreciation over the long haul.
Commercial Real Estate as an Inflation Hedge
Commercial real estate boasts a track record of preserving or even enhancing its value during inflationary periods, positioning it as a steadfast long-term investment. This makes it an appealing choice for investors seeking stability amid economic fluctuations.
However, the effectiveness of commercial real estate in safeguarding against inflation depends on various factors. Investors should consider these elements before committing to a commercial real estate (CRE) investment.
Type of Underlying Debt: Commercial real estate investments are typically financed through a combination of equity and debt, often in the form of mortgages. The sensitivity of different mortgage types to fluctuating interest rates varies. Mortgages with fixed-rate interest provide stability against market rate changes, whereas floating-rate (variable interest rate) debt adjusts based on market conditions or a specific reference rate.
Lease Duration: Shorter leases offer flexibility for investors to swiftly adjust rents in response to inflation. Lease terms vary based on property type; for instance, hotels can adjust room rates daily. Co-working spaces and alternative sectors often feature month-to-month leases. While multifamily properties usually have short-term leases, office, industrial, and retail leases tend to be longer (10-20 years), making it challenging to renegotiate terms during unexpected inflation. Longer leases may include escalation clauses that raise rent annually, which may or may not match inflation rates.
Supply and Demand Dynamics: Property types benefiting from long-term trends tend to maintain robust demand and positive rent growth regardless of macroeconomic changes. For instance, the multifamily sector thrived due to cultural shifts in the pandemic's wake, while the industrial sector experienced increased demand due to digitalization and widespread e-commerce adoption. In contrast, sectors like regional malls and suburban offices faced headwinds due to hybrid work arrangements and reduced consumer spending, further exacerbated during inflationary periods.
Type of Commercial Real Estate Property: Investors should direct their attention towards property categories poised to demonstrate robust, structurally-rooted demand and genuine rent escalation, especially in scenarios of elevated inflation. As depicted in the image below, apartments and industrial properties have excelled in countering inflationary pressures due to their inherent demand resilience, further bolstered by lease frameworks that offer landlords a valuable advantage.
Image: Annualized total returns for U.S. property types compared to inflation from 1978 to 2022
While commercial real estate isn't entirely immune to inflation, its track record showcases strong performance during periods of above-average inflation due to its capacity to generate and enhance income returns for investors, often through leases linked to inflation metrics. Taking a comparative stance, data from the 1970s, characterized by high inflation and sluggish growth, indicates that commercial real estate fares better than traditional assets in safeguarding real returns. In a world centered on relative value, this positioning could prove advantageous for both real estate and balanced investors seeking strategies to offset heightened inflation concerns.
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Q1. Is commercial real estate a good inflation hedge?
A. Yes. Commercial real estate is frequently acknowledged as a robust strategy for countering inflation in the long run. Also, commercial real estate isn't entirely immune to inflation. But, its track record showcases strong performance during periods of above-average inflation. This is due to its capacity to generate and enhance income returns for investors, often through leases linked to inflation metrics.
Q2. What is the best real estate during inflation?
A. The best real estate during inflation is commercial real estate. Commercial real estate is frequently acknowledged as a robust strategy for countering inflation in the long run. It showcases strong performance during periods of above-average inflation. This is due to its capacity to generate and enhance income returns for investors, often through leases linked to inflation metrics.
Q3. What happens to real estate prices when inflation goes up?
A. Real estate prices tend to increase during inflationary periods as the costs of materials and labor surge, causing a ripple effect on property values. Inflation can lead to higher real estate prices due to elevated construction and operational costs, driving up demand for existing properties. When inflation rises, real estate prices often follow suit, driven by higher production expenses and increased demand for properties as a hedge against inflation.
Q4. Do property investors benefit from inflation?
A. Yes, property investors can benefit from inflation by investing particularly in commercial real estate. In an inflationary ecosystem, expenses rise, yet the silver lining is that commercial real estate property owners can counterbalance the impact of escalating costs by augmenting rental rates. Furthermore, surplus income can be reinvested at more lucrative interest rates, consequently bolstering overall returns.