INFLATION TRENDS AND EFFECT ON COMMERCIAL REAL ESTATE 2023

The potential to raise rent and the possibility of constant income for owners make commercial real estate a popular long-term inflation hedge. Investors seeking to protect their wealth and the long-term performance of their portfolio in such an inflationary market climate may think about diversifying into real estate. Commercial real estate or CRE is one of the best ways to hedge against inflation. CRE may offer a reliable stream of revenue and enable owners to partially offset their rising expenses by raising the rent.

Historically, commercial real estate has performed well during various economic downturns. Over 87% of the time in the past 25 years (1978–2022), commercial real estate in the United States has beaten inflation.[2] The late 1970s and early 1980s saw considerable inflation during this time period.

However, in 2023, it is anticipated that commercial real estate prices will fall, there will likely be a significant increase in employment, which will likely improve organizations’ and employees’ financial situations, and investment strategists anticipate lower inflation rates all year long. This year, commercial real estate investors will handle their portfolios differently due to the anticipated economic shift. Let’s look at 10 commercial real estate trends for 2023 to have a better sense of how the upcoming months will impact your assets.

Inflation Trends And Effect On Commercial Real Estate 2023

• Price Increases and Purchasing Power

A person’s ability to buy has a substantial impact on inflation. The worth of products or services that may be purchased with a single unit of any currency (such as $1) is referred to as purchasing power. Generally speaking, a rise in the cost of products and services results in less money in your wallet. You won’t be able to buy as much for the same price as you formerly could if prices rise.

For instance, a pound of coffee cost $4.43 in 2020 but averaged $6.4 in December 2022. Coffee bean shortages and trade interruptions have considerably increased the price. Two years ago, $5 could get you a pound of coffee, but now, you’d need an extra $1 to obtain the same thing. Therefore, your purchasing power is less now than it would be in 2020. The home market is undoubtedly impacted by this reduction of buying power during an inflationary period.

The cost of borrowing (debt, mortgages) increases if the central bank raises interest rates to control rising inflation (as the Federal Reserve has done). It becomes more difficult for purchasers to find real estate within their price ranges when mortgage rates rise.

According to a recent study, a homeowner in the United States in 2021 with a $2,500 monthly mortgage budget might afford to buy a house valued up to $517,500. However, because of the increase in interest rates in 2022, the buyer could only able to afford a $399,750 house.

The increased mortgage rates caused the purchaser to lose $120,000 in purchasing power. High inflation and interest rates also impact the supply side of the equation.

The higher price of raw materials, labor, and machinery coupled with greater borrowing costs make it costlier for developers to construct new properties. This is likely to reduce the overall housing inventory. Existing properties, therefore, appreciate in value, particularly in high-demand sectors like multifamily.

Fewer people are able or willing to purchase real estate, which has increased the demand for rental homes. Mortgage payments are apparently more than the average rent at present in 45 of the 50 largest US metro areas, making homeownership more expensive than renting a room. A long-term investor in commercial real estate may profit from the spike in demand and strong occupancy rates by raising rents.

• Real estate as a hedge against inflation

Commercial real estate is regarded as a reliable long-term investment since it historically has grown or maintained its value and overall performance throughout inflationary periods. CRE is often viewed as an alluring inflation hedge as investors may raise rental prices for fully developed properties to account for higher operational expenditures or greater demand.

Depending on the kind of loan, lease tenure, supply/demand factors, and cap rate change, a certain asset’s capacity to hedge inflation may differ. Before selecting their CRE investment, investors may wish to take these aspects into account.

1. Type of underlying debt: To fund a real estate venture, investors often combine equity with debt (such as loans given in the form of mortgages). The degree to which different mortgage types are sensitive to interest rates varies.

When compared to properties with floating-rate (also known as variable interest rate) debt, a mortgage funded with fixed-rate interest for the duration of the loan will be more stable. These mortgages change in accordance with the state of the market or a predetermined reference rate).

2. Lease Length: Shorter leases enable investors to quickly adjust rents or modify lease agreements to take inflation into account. The type of property determines the lease’s duration. Hotel room rates, for instance, might change every day. Month- to-month contracts are common in alternative industries like self-storage and co-working office spaces. Short-term leases are    frequently available in the multifamily sector, with a 12-month period being the most popular.

Conventional leases for commercial, industrial, and retail space, on the other hand, tend to be lengthier (10–20 years, in certain situations), making it challenging for landlords to immediately renegotiate terms during times of unforeseen inflation. Escalation provisions are frequently included in such lengthier leases. These only modestly raise the rent each year, sometimes not even enough to keep up with increased inflation rates.

3. Drivers of structural supply and demand: Regardless of the macro situation, there will likely be strong demand for and positive rent increases for property types that benefit from long-term trends. Consider the multifamily industry, which profited from the cultural changes in our daily routines that increased in the early epidemic years. Due to the quick adoption of commerce and fast digitalization, demand in the industrial sector also increased.

However, there are still challenges for suburban office buildings and regional malls. Reduced consumer spending and the move toward hybrid work have decreased  occupier demand, increased vacancies, and decreased income. When there is inflation, this is made worse.

4. Cap rate change: The relationship between a property’s present market value and its net operating income (NOI, which is the asset’s predicted yearly income less management costs), is known as the capitalization (cap) rate. Before considering mortgage financing, the prospective cash return of a property is calculated using the cap rate.

The estimated risk and return levels for a property often rise when cap rates rise. This occurs as a result of the property’s worth being determined from either larger anticipated future cash flows or a lower present valuation. Cap rates that compress signify a rise in the property’s existing equity worth.

In general, lower cap rates are advantageous to property owners since they may signal an increase in the value of their assets. Interest rates, inflation, rent growth, the Gross Domestic Product (GDP), employment, and the location and industry of the property are some of the variables that affect cap rates. All of these elements can reduce the effect of inflation on cap rates.

Theoretically, higher interest rates would result in a cap rate expansion, but this effect may be mitigated by increased NOI or a sector experiencing favorable growth trends. Your expectations for cap rates and your choice of investments should be based on your risk tolerance as an investor, especially during times of rising inflation.

Some properties do better than others, even though practically all privately held commercial real estate may offer superior protection against inflation than equities and bonds. When inflation rose beyond 5% in the past, privately owned multifamily apartment complexes outperformed their contemporaries. During such times, multifamily investments achieved returns of 12.71 %. Industrial assets came in second with returns of 11.72%.

An environment with high inflation and rising interest rates might be beneficial for long-term real estate investors. The holding length of your investment, the kind of property, the kind of financing, and the asset’s underlying lease arrangement will all have an impact on the outcomes.

The correct investment may enable you to optimize net operating income, preserve or improve the property’s total worth, and produce the greatest risk-adjusted returns for your portfolio despite inflationary pressures on cap rates and real estate prices.

Five Trends To Watch In Commercial Real Estate In 2023

• The Preferred Option Is Smaller Properties With Shorter Leases.

Many businesses that once needed many levels of office space have switched to remote or hybrid work models. They now want a place that can accommodate their flexibility needs as a result.

Tenants increasingly look for just enough space for the requirements rather than tens of thousands of square feet for offices, conference rooms, break rooms, “bullpen” space, kitchens, waiting areas, and more. Furthermore, because flexibility is so important, many businesses will favor renting from landlords that have possibilities for short-term leases.

• Capital Recovery

Finding funding alternatives has proven challenging for some investors due to rising interest rates and more stringent lending criteria. These CRE investors are afraid that tighter underwriting and lending assumptions will continue to impede the expansion of their portfolios, according to the H1 2022 Cap Rate Survey.

Capital recycling, or the practice of leveraging current assets to finance future investments, has consequently gained popularity in the CRE investment sector. This can be an excellent way to maximize returns for investors without a lot of liquid cash.

• Cutting-Edge Technology

Even if we anticipate a better financial future for commercial real estate, investors will still look for ways to save money. Commercial real estate investments will no longer accept the absence of technology that automates manual tasks, manages building operations (HVAC, security features, etc.), and records expenditure and income.

• Additional Operational Property

The need for operational real estate is rising, including for elder living communities, storage facilities, and accommodation for students. Between 2020 and 2021, total CRE investments in operational real estate almost quadrupled, accounting for little over 12% of the annual global investment volume.

Operational real estate will be a well-liked and lucrative industry as more Americans want healthcare, student housing, and storage solutions.

• The Reemergence Of Multifamily Housing In Cities

Millions of people found crowded cities unsettling during the epidemic or decided they didn’t need to live there anymore as a result of their employers’ shift to remote employment. They thus migrated to the suburbs.

We see that employees want to relocate back to cities when businesses resume operations, public health worries fade, and solid employment growth continues.

Multifamily real estate investments have been rising by 56% year over year, reaching $63 billion in Q1 2022, the greatest first quarter the industry has ever seen.

As informed investors, we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.