Increasingly, all eyes in the investment community are paying close attention to rising inflation rates. Over the past 12 months, the pace of inflation has accelerated faster than any other year-over-year period since the Regan Administration. By December 2021, the annual inflation rate had skyrocketed to a staggering 6.8 percent.
Over the past 12 months, the pace of inflation has accelerated faster than any other year-over-year period since the Regan Administration.
In inflationary environments, cash – usually considered one of the “safest” investments – is the worst place to invest. Cash, whether held in checking, savings or high yield accounts, will usually earn less than 1 percent annually, well below the rate of inflation. In other words, those who hold cash are actually losing purchasing power during periods of inflation.
Yield-seeking investors are instead looking at alternative assets, like real estate, to grow their portfolio returns.
That begs the question: how does real estate perform, generally, during inflationary periods? More specifically, which real estate asset classes do best when the inflation rate rises? Read on to learn more.
What is inflation? Inflation refers to a general rise in prices for all goods and services, across all sectors. As inflation rises, consumers’ purchasing power decreases. For example, whereas it may have cost $2.25 for a gallon of gas last year, an uptick in inflation can cause that same gallon of gas to cost $3.00 or more this year.
Two Types of Inflation: Demand-Pull and Cost-Push
There are two primary causes of inflation.
The first is referred to as “demand-pull” inflation. With demand-pull inflation, the demand for goods and services exceeds the economy’s ability to produce them. Therefore, goods end up in short supply, which puts upwards pressure on prices.
The second type of inflation is called “cost-push” inflation, which is when the raw costs for certain goods or services increases and therefore, the final cost for those products or services increases as well. For example, the rising cost of certain foods has put pressure on restauranteurs trying to hold prices steady. Meanwhile, finding reliable, qualified labor has become more challenging. In response, many restaurants are paying new employees more per hour than ever before. This combination of factors – higher food costs and higher labor costs – has all but forced restaurants to raise their menu prices.
Since the end of the Great Recession, the inflation rate has hovered around 1-3 percent per year. Today, the inflation rate has more than doubled, which is why investors are sitting cautiously on edge.
How does inflation impact commercial real estate?
There are many ways that inflation impacts commercial real estate. For example:
· As the cost for building materials and labor increases, new construction often becomes cost prohibitive. More expensive buildings require owners to charge higher rents, and in some markets, the rents the landlords will need to achieve to make a deal pencil out simply aren’t attainable. This stalls the construction pipeline, which in many cases, bodes well for existing property owners who benefit from the lack of new competition. With less supply available, demand for existing assets increases and landlords can push rents accordingly.
· If interest rates rise, the prices for commercial real estate tend to come down. During recessionary periods, the Federal Reserve Bank typically lowers interest rates. This makes it more affordable to finance commercial real estate, in turn, allowing investors to spend more per property. The opposite is true during inflationary times. As inflation rises, the Federal Reserve Bank typically increases interest rates – as they are now contemplating doing. If and when that happens, it will likely have a cooling effect on the values of commercial real estate.
· Properties with fixed-rate debt tend to outperform those with floating-rate debt. As noted above, interest rates tend to rise as inflation escalates. Commercial real estate owners who have fixed, long-term debt on their properties will generally fare better than those with adjustable, floating-rate debt. For example, someone who finances a property with 3.75% fixed-rate interest is generally less concerned about inflation than someone whose interest rate can adjust periodically up or down. If the rate of inflation is 6.5%, someone with fixed-rate debt below that level will benefit from their in-place interest rate, especially if they can increase rents at the same time.
· Inflation’s impact on individual commercial real estate landlords often depends on their lease structure. Inflation does not impact all property types equally, as we’ll see below. Owners who can increase their rents above and beyond the rate of inflation generally fare well during inflationary periods. This is one reason why multifamily shines during recessionary periods; leases generally turn over on an annual basis and owners can restructure the lease each year as the rate of inflation goes up or down. This can be more challenging at office, retail and industrial properties in which tenants are often on long-term leases. Unless those leases have built-in cost escalations (and ideally, escalations tied to the rising Consumer Price Index (CPI)), then those owners may be more adversely impacted by rising inflation.
Real Estate Asset Class Performance During Recessionary Periods
According to a recent in-depth analysis by Berkadia, all U.S. private CRE property types tend to become more favorably sensitive to rising inflation when volatility is higher.
Let’s look at the chart above.
The chart above shows how different commercial real estate investments perform under different inflation scenarios. The green bar represents inflation rates between 0-2%, the red bar represents inflation of 2-5%, and the blue bar represents scenarios in which inflation is 5% or more.
As shown above, privately-owned multifamily apartment buildings tend to perform especially well during periods of high (5%+) inflation. Industrial also performs well, which comes as no surprise given the exponentially high demand for industrial assets in recent years.
Privately-owned multifamily apartment buildings tend to perform especially well during periods of high (5%+) inflation.
Private office and private retail still generate positive returns, but they are not as well-positioned as multifamily or industrial. The outlook for office and retail moving forward remains somewhat unclear. Demand for office is generally low right now, so in the short-term, it may not pose as strong of a hedge against inflation. Meanwhile, retail – which has historically been quite good at delivering short-term inflation protection as retailers are usually quick to incorporate price changes into their business models – may struggle as brick and mortar retailers face growing competition from and/or shift their own businesses more toward e-commerce.
The hotel industry fares the worst of all CRE asset classes as inflation rises.
Is real estate a strong hedge against inflation?
Most investors classify an inflation hedge as any asset which beats inflation over the long-run. This is certainly an oversimplification. Using this rationale, many have also come to conclude that stocks are also potent inflation hedges, and by association, they assume that REITs also have powerful inflation-hedging properties.
However, data indicates otherwise.
As shown in the chart above, post-Global Financial Crisis, higher inflation tends to help private CRE returns while hurting REIT and stock returns. Specifically, research shows that the risk-adjusted returns for privately-owned commercial real estate tend to be higher during recessionary times.
Investors looking to hedge against inflation will certainly want to consider adding commercial real estate to their portfolios.
Therefore, investors looking to hedge against inflation will certainly want to consider adding commercial real estate to their portfolios. The investment vehicle will matter: direct ownership in commercial real estate will tend to outperform investments in REITs or real estate mutual funds. Those who wish not to own real estate directly should consider investing in a joint venture, real estate syndication, Delaware Statutory Trust (DST), or other fractional ownership structure.
Investors should pay close attention to CRE asset class, as well. As shown above, industrial is particularly attractive during inflationary times – be it low inflation (0-2%) or high inflation (5+ %).
How CRE Owners Can Respond to Rising Inflation There are a few tools that CRE owners have at their disposal to help them get ahead of rising inflation rates. Strategies include:
· Reintroduce rental lease CPI indexation. Such clauses were common in rental leases during the 1970s and 1980s. Then, as inflation came down, they tended to disappear. Owners (of any CRE asset type) will want to consider reintroducing language into their leases that requires rent escalations to be no less than the current rate of inflation (i.e., tie to the Consumer Price Index).
· Introduce period rent reviews. Another way to shift both market and inflation risk to tenants is by requiring periodic rent reviews. This is common in most leases in the UK, but is less standard in the U.S. commercial real estate market. Lease clauses like these are especially important with longer-term leases.
· Where possible, shift operating costs to tenants. While this may require some drop in gross rent levels, to the extent that operating costs rise faster than CPI inflation, the growth rate of net rental income should increase correspondingly. Of course, this assumes a property is fully occupied. If there is a lot of vacancy, landlords start to lose their bargaining power (something that has not recently been an issue for those who have invested in industrial property!).
· Capitalize on cheap debt. Current interest rates are still remarkably low. Any owner who has floating-rate debt should consider refinancing into stable, fixed low-cost debt while it is still available.
Conclusion
As shown here, commercial real estate can be a tremendous hedge against rising inflation rates. This is especially true for those considering investing in industrial real estate, though all privately-owned real estate will prove to be a worthwhile addition to any investor’s portfolio.
Are you considering purchasing industrial real estate? Contact us today. Our team would be happy to discuss the benefits of owning industrial property with you, and can help guide you on your search to finding the right investment opportunity.
About the ComReal Miami Industrial Team: The ComReal Miami Industrial Team has been assisting companies with their South Florida real estate needs for over 30 years. The industrial team specializes in the sales and leasing of industrial properties. Visit Warehouses Market and/or call 786-433-2380 for more information.
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