People can generally consider inflation to be a normal part of an economy. Inflation is when prices of goods and services rise over time. However, high inflation can pose a problem for investors. Similarly, it decreases purchasing power, as your money will not go as far as before. After all, while high levels of inflation can make people better off financially, in the long run, they may not be happy in the short term as prices increase across all sectors of the economy.
It’s no secret that in recent months, Americans have noticed an incredible surge in prices of goods and services, from gas to groceries to construction. The impacts of a multi-year-long pandemic, economic uncertainty, and labor shortages have led prices to rise.
For the past 10 years, the average rate of inflation in the United States was 1.8%. This has been the average over the last decade, but many experts are now calling for higher-than-normal rates of future inflation due to the impacts of COVID-19 on the economy. Shuttered businesses, people out of work, and large injections of stimulus money from the federal government have set the stage for an unprecedented scenario.
Inflation, rising interest rates, and recession fears have officially begun taking a toll on commercial real estate. Commercial property prices dropped 3.7 percent between May and June, according to recent research on the Commercial Property Price Index carried out in the second quarter of 2022. The total drop in commercial property prices from a high in March has been well over 4.9 percent.
Commercial real estate is an interesting asset class with unique characteristics, particularly in today’s high inflation environment with growth now beginning to slow due to sharply rising interest rates. Commercial real estate as a protection against inflation is a long-standing rule of thumb. It’s an asset class that generates predictable cash flow, and some leases have the option of raising rents alongside the consumer price index.
Commercial real estate (CRE), like other tangible assets, tends to appreciate in value proportionate to inflation. Recently, the rate of inflation has increased markedly. Interest rate increases and inflation may drive price fluctuations, but I think there are more driving changes in the real estate market. The pandemic has changed how people use real estate.
Inflation’s Effect on Commercial Real Estate
Various factors influence the relationship between commercial real estate and inflation. Generally, when inflation causes prices and wages to rise, rents and values usually go up. Commercial real estate is often valued based on net incomes, so rents and expenses should also rise or increase in cooperation with inflation. Varying economic conditions and other factors may however not make this the case at all times.
Interest rate increases and inflation may drive price fluctuations, but I think there are more driving changes in the real estate market. The pandemic has changed how people use real estate. Inflation will have a direct impact on property construction and operating costs, as the market has already experienced it since early this year. Some higher costs have been driven by supply chain disruptions that have begun to moderate and will continue to seek equilibrium. However, some expenses are likely to remain high for the foreseeable future.
Wages and benefits, in particular, appear to have reached a new plateau given an incredibly robust job market and ubiquitous worker shortages. Utilities are also likely to remain high due to geopolitical forces and more unpredictable and severe climates in many parts of the country. Climate change is also driving up the cost of property insurance.
Real estate as an inflation hedge relies on the ability to grow rent faster than inflation-impacted costs. That, in turn, is dependent on property type and market, and how frequently the operator can adjust rent (i.e., the length of the lease). During the last decade, the stability of long-term leases was prized by investors, but now they are taboo unless the lease has frequent and meaningful escalation clauses.
Owners of properties with short-term leases such as hotels, self-storage, and multifamily can most take advantage of an inflationary lift in rent. But that is only if there is increasing demand in the market against a backdrop of limited supply. In other words, the effectiveness of the inflation hedge depends on the right circumstances, most importantly being in a market with continued in-migration and job growth.
During the first half of 2022, it has been largely attributable to the effects of a widening trade deficit, inventories, and a reduction in government consumption. Commercial real estate doesn’t provide the same protections against inflation across all sectors. For example, apartment buildings and industrial real estate demonstrated the highest returns in private real estate. Retail used to be an effective protection against inflation because of the nature of its shorter-term leases; however, since COVID-19, more retail has moved online, and the market changed.
Tighter financial conditions tend to have a direct impact on commercial property prices by making it more expensive for investors to finance new deals or refinance existing loans, thereby lowering investment in the sector. They could also have an indirect impact on the sector by slowing economic activity, and reducing demand for commercial property such as shops, restaurants, and industrial buildings.
A sharp tightening in financial conditions could thus put the commercial real estate sector under renewed pressure, especially in regions where economic growth prospects are weak. On one hand, commercial real estate investments are viewed as an inflation hedge as values typically rise at the rate of inflation rise. On the other hand, values are affected by changes in cap rates, supply and demand, and inputs such as commodities, labor costs, and financing availability.
Commercial real estate valuations can be influenced by the present-value effect of interest rates. However, increases in interest rates have often corresponded with rising inflation, which puts upward pressure on real estate rents and property values. This increase in property income, or potential income, has been helping to offset the spring and summer 2022 rise in interest rates.
Likely positives during times of high inflation are rising prices for rental property rates. During high inflationary times, it can be difficult to get a mortgage. High-cost mortgage rates mean buyers have less purchasing power, so many continue to rent. This surge in demand results in increased rental rates, which is great for landlords.
While appreciation is a distinct and separate market analysis, in general, housing prices tend to rise in an inflationary economy. Real estate has intrinsic value; people need roofs over their heads regardless of the value of their currency. If you’re able to offer favorable terms for private mortgages, you’ll likely have a line out the door.
A potential negative for a real estate investor in inflationary times is the increased cost of borrowing debt. To make sure the bank doesn’t get shorted, they’ll charge higher interest rates and offer fewer loans. Increased costs of building materials for new homes are another disadvantage.
Between the high cost of borrowing and the additional cost to build, new construction can be a very difficult investment during inflation. When pockets get tight, travel usually gets cut from the budget pretty quickly. Vacation rentals, locations that are driven by tourism, or retirement communities may not fare as well as other forms of real estate investing.
CONCLUSION
inflation is a complex economic phenomenon with various potential impacts on commercial real estate. Adjusting investment and property management strategies can yield a positive return on commercial property prices if the goal is to sell. Typically during times of inflation, your commercial property price will appreciate.
It’s important to note that commercial property only acts as a hedge against inflation for real estate investors who already own property and have secured low-interest loan rates. During times of inflation, commercial property prices could soar, so it’s always wise to carefully and strategically consider when and where to purchase your first investment property.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
Effect of inflation on commercial real estate?
Various factors influence the relationship between commercial real estate and inflation. Generally, when inflation causes prices and wages to rise, rents and values usually go up. Commercial real estate is often valued based on net incomes, so rents and expenses should also rise or increase in cooperation with inflation. Varying economic conditions and other factors may however not make this be the case at all times.
