Can Commercial Real Estate Serve as a Hedge Against Inflation?
Is Inflation Coming?
July 8, 2021 | James Sprow | Blue Vault
Recent surges in the prices of commodities may or may not be harbingers of future inflation. The remarkable run-up in lumber and re-bar prices have now abated, but the consumer price index that represents a broad measure of prices and inflation is a far better proxy than a few select commodities. As the Wall Street Journal stated recently, “… while inflation’s 13-year high, as measured by the annual change in the consumer-price index from a year earlier, has caused concern, the central bank restated its belief that the rise in prices is ‘largely reflecting transitory factors.’”
One of the approaches that tends to over-state the impact of inflation so far in 2021 is the comparisons made to the prior year’s price changes, since 2020 was clearly an anomalous price environment. During the pandemic prices fell due to lockdowns, which then creates a set of comparisons which can overstate the changes in prices when looked at on a Y-O-Y basis. In the same June 22, 2021 Wall Street Journal article, consumer prices are compared to pre-pandemic levels, which eliminates the distortions in price increases that are due to the pandemic’s lockdown effects.
The talk of inflation is sending many investors scrambling, and understandably so. Fortunately, for those invested in real assets, inflation has quite the opposite response, and in many cases, even results in positive returns. Looking back at prior periods of inflation in relation to commercial real estate, property values and rent levels have increased. Given that those two items are primary drivers of real estate returns, a natural inflationary hedge is built into almost any real estate investment, providing security in times of economic volatility.
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:
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.
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 on a 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 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:
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, short-term yields 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. The values of these properties can behave much like the value of bonds of longer duration. Higher rates imply lower values and vice versa.
Some commercial real estate types fare better
The flexibility that landlords enjoy in adjusting rents as inflation occurs can have a major impact on returns. For example, multifamily, hospitality and self-storage all have the flexibility in adjusting rental rates and room rates that allow landlords to compensate for inflating expenses. Multifamily assets are usually leased on an annual basis, and occupancy turnover allows property managers to adjust rents upward when inflation increases other costs of living and property expenses. Hotel properties have the flexibility to adjust room rates on a daily basis, dealing with the ebbs and flows of both occupancy and operating expenses. Self-storage properties can also adjust rates on a month-to-month basis, and operating expenses are typically so much lower than other asset types that inflation does not have as great an impact on the bottom line.
On the other hand, office properties typically have longer-term leases, even 10 to 20-year terms. With those assets, escalating clauses that are not tied to the CPI can cause values to be negatively impacted when inflation increases. Property operating costs are also higher in relation to lease revenues, so wage and price inflation impacts the bottom line as well. Industrial properties with single tenants can have longer leases as well, where escalation clauses can be crucial in protecting owners from the erosion in value due to inflation. Single-tenant, stand-alone retail properties will also typically have long leases and low turnover. Other asset types, such as data centers, health care, and infrastructure such as cell towers may have long leases as well, making escalation clauses important.
In summary, the length of leases, escalation clauses, and tenant turnover all play a role in how commercial real estate can be impacted by inflation and how owners can adjust.
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.
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.
Sources: Wall Street Journal and miscellaneous other articles
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