How Commercial Real Estate Serves As A Hedge Against Inflation

What is inflation?

As the Federal Reserve continues to inject money into the economy, many people are starting to fear that inflation is on the horizon. When inflation occurs, the value of the US dollar is weakened; in turn, causing an increase in price of goods and services. This is a basic economics term that essentially increases the cost of living, though it affects all aspects of the economy… consumer spending, investments, employment, etc. A moderate amount of inflation can actually be a sign of a healthy economy, and with the pandemic’s end in sight, it’s expected that pent-up demand will result in an increase in consumer spending.

But for certain investors, inflation can be detrimental. Shares in publicly traded companies and bonds can drastically change in value overnight due to a variety of micro and macroeconomic factors unrelated to the investments themselves.

The Effect of Inflation on Real Assets (Like Commercial Real Estate)

While inflation can hurt intangible investments and those subject to daily market fluctuations, it can actually strengthen commercial real estate investments and many other real assets. In the commercial real estate space, investors can mitigate risks and take advantage of inflationary protections in a few different ways:

1. Increase in labor and material costs creates limited supply
   With costs of production on the rise, new projects become very expensive, which leads to a limited supply of buildings at a relatively lower cost basis (compared to expected costs for new building development). In the short run, this causes a rise in both rental rates and property value. Most commercial real estate leases are structured to include annual rent increases, which helps protect property owners from the increase in expenses due to inflation. Thus, existing real estate assets can serve as tremendous hedge against inflation.
2. Ability to adjust rent prices as property value increases
   Rental rates rise alongside general prices. As property values increase, higher cash flow can be generated by increasing rental rates at your property. With interest rates at historic lows, borrowers can lock in long-term debt at low interest fixed rates. Combining increasing cash flows with low cost of capital effectively enhances your returns.

Factors that Impact Successful Commercial Real Estate Investments with Inflation

Though most commercial real estate properties perform well with inflation, there are certain aspects of these investments that can affect how well they do. Lease duration, the investment hold period, and premiums on existing assets are a few examples of contributing factors; here’s how they play a role:

1. Lease Duration
   As it relates to commercial real estate performance during higher inflationary periods, returns may depend on how leases are structured. Some of the most positively affected properties are those with shorter term leases that allow for rental rate adjustments once the leases have expired. When higher levels of inflation are expected, you can see short term yield increase with inflation. Investments with long-term leases that have flat rental rates are not positioned particularly well to capitalize on inflation, despite their stability.
2. Investment hold period in relation to the inflation cycle
   High inflation rates typically cause the Fed to raise interest rates; when interest rates are higher, it becomes more expensive to borrow money. Because many real estate investors use debt to purchase assets, this increase in cost of debt leads to less demand and causes a decrease in commercial real estate value. Therefore, it is not an opportune time to sell. Many investors choose to wait until inflation is stabilized and rates are lowered again.
3. Inflationary pressures put a premium on existing assets
   As previously mentioned, inflation leads to an increase in material and labor costs and makes it costly for firms and individuals to borrow money, due to an increase in interest rates. Because of these two factors, developers are much less incentivized to build new properties, ultimately limiting supply and setting a premium on higher quality, existing assets.

The Bottom Line

As inflation nears, those invested in real assets, like commercial real estate, can expect a wave of momentum in the coming cycle. This is a very unique time for CRE investors; with multiple yield generating opportunities, there are ways to position existing portfolios to result in positive returns, unlike most investments during inflationary periods.