Inflation in the U.S. has reached levels not seen since the 1980s due to various factors like supply shortages, higher commodity prices, and geopolitical uncertainties. In such an inflationary market, investors seeking wealth preservation and long-term portfolio performance should consider diversifying into real estate, particularly commercial real estate (CRE). CRE is known for its resilience against inflation, providing stable income and the potential for rent increases. In this blog post, we will explore the relationship between inflation and commercial real estate, highlighting its advantages and the best investment opportunities during high inflation.
Inflation and Purchasing Power: Inflation significantly affects purchasing power, which refers to the value of goods and services that can be purchased with a given currency. As the price of goods and services increases, purchasing power decreases. For example, the average price of a pound of coffee rose from $4.43 in 2020 to $6.4 in December 2022 due to supply shortages and trade disruptions. This erosion of purchasing power affects the housing market, making it harder for buyers to afford properties as mortgage rates rise.
Increased Demand for Rental Housing: As purchasing power diminishes and buying property becomes more challenging, the demand for rental housing increases. Mortgage payments in many areas have exceeded average rents, making home ownership more expensive than leasing. Investors in commercial real estate can benefit from this surge in demand and high occupancy levels by raising rents, thereby capitalizing on the rental market’s upward trend.
Impact on the Supply Side: High inflation and interest rates also impact the supply side of the equation. Rising raw material and labor costs, coupled with higher borrowing costs, make it more expensive for developers to construct new properties. Consequently, the overall housing inventory decreases, causing existing properties, especially in high-demand sectors like multifamily, to appreciate in value.
Commercial Real Estate as an Inflation Hedge: Commercial real estate has a history of maintaining or increasing its value during inflationary periods, making it an attractive long-term investment. Investors can adjust rental rates to compensate for higher operating expenses or increased demand, making CRE a reliable hedge against inflation.
Factors to Consider in Commercial Real Estate Investments:
- Type of underlying debt: Properties financed with fixed-rate interest throughout the loan period are more stable during fluctuating interest rates than those with floating-rate debt.
- Lease duration: Shorter leases allow investors to promptly revise rents to account for rising inflation. Different property types have varying lease durations, with some offering more flexibility for rent adjustments.
- Structural supply/demand drivers: Properties benefiting from long-term trends, such as the multifamily and industrial sectors, are likely to experience robust demand and positive rent growth during inflationary periods.
- Cap rate movement: Capitalization (cap) rate, which measures a property’s potential cash yield, is influenced by factors such as interest rates, inflation, and property location. Understanding cap rates and their relationship to inflation is crucial for investment selection.
Best Investment Opportunities: Historically, privately-owned multifamily apartment buildings have outperformed other property types during periods of high inflation, generating returns of 12.71%. Industrial assets are the second-best performers, achieving returns of 11.72%.
In an environment of high inflation and rising interest rates, commercial real estate can offer significant benefits to long-term investors. The specific outcomes depend on factors such as investment duration, property type, financing, and lease structure. While inflation can put upward pressure on cap rates and real estate prices, strategic investments can maximize net operating income, maintain or increase property value, and generate favorable risk-adjusted returns. By understanding the relationship between inflation and commercial properties, investors can make informed decisions to preserve their wealth and achieve long-term portfolio growth.
