Inflation Inflating Commercial Real Estate Returns
Everyone has felt the effects of Covid-19, ranging from personal health to the world economy. In the United States specifically, one of the long-term effects of the pandemic is inflation. Inflation is inevitable, but post-covid inflation rates have skyrocketed compared to societal norms. Normally, the Federal Reserve aims for the inflation rate to be approximately 2% annually. However, the government loaning out trillions of dollars throughout the pandemic for relief has caused inflation to go up to as much as 8.5% (Wall Street Journal, Guilford, 2022). Increased inflation could have dramatic economic effects on many sectors of the economy. This article will look at the effects inflation has on commercial real estate and if real estate is a worthwhile investment during times of high inflation rates.
For investors, there are many reasons why commercial real estate is a great investment in times of inflation. An obvious reason is due to the high barriers of entry to invest in commercial real estate. During times of high inflation, these barriers of entry only get higher since the resources used to make a commercial property are more expensive causing the land, construction, and the whole process to be less feasible. If you already have a commercial property, your investment will appreciate inflation if you were looking to sell your asset.
Furthermore, investors do not need to worry about their cash flow decreasing due to high inflation. The opposite occurs. When inflation goes up, the rents go up with it which leads to a higher cash flow. Through simple analysis, it is evident that with every 1% increase in inflation there is a 1.1% increase in total returns (Cushman & Wakefield 2021, Bitner, Thorpe, and Rockey). Thus, experts argue that inflation strengthens commercial real estate.
The critical importance of leases to commercial real estate makes commercial real estate investing a safe investment. Leases lock clients into deals. Many leases are short-lived and have clauses to protect the owners from extreme inflationary circumstances. These clauses, in some instances, can be looked at as insurance for inflation. If inflation goes up dramatically, so will the rent of the tenant and the lender will not be harmed by inflation. Also, since the leases are short-lived, this allows owners to renegotiate with clients and make new contracts so they can be compensated properly according to the current dollar value (JLL, Severino, 2022). These owners and investors are protected in extreme cases such as the present inflation we face at 7.5%.
Interest rates play a key role in this dynamic between commercial real estate and inflation. An interest rate is an amount that a lender charges a borrower and it is a percentage of the amount of money that the borrower loaned. In the commercial real estate world, the interest rate is based on what the Federal Reserve decides to set as the rate of interest depending upon the circumstances. (Investopedia, Banton, 2021). Rising inflation can positively affect your investment while interest rates remain low. However, on the flip side, if inflation rises and interest rates rise with it, then this phenomenon has the potential to push up cap rates and lower returns. (CBRE, Blake, Mowell, Ren, 2021).
Important counterarguments are necessary for this inflation phenomenon. Not always can landlords pass these inflationary pressures on tenants. In certain cases, the market can be oversupplied. An oversupplied market means landlords will rent to anyone and everyone. This in turn brings the cost of rent lower than the landlords want in order to meet these inflationary pressures. (CBRE, Blake, Mowell, Ren, 2021). The specific type of inflation is important for commercial real estate to thrive in times of inflation. It can be argued that when stagflation occurs because of a higher cost of goods, it can hurt the investment. This is because vacancy is up and fewer people demand real estate (CBRE, Blake, Mowell, Ren, 2021).
Investors look to have returns even in down markets. They look for the best way to hedge their investments in times of inflation and all economic circumstances. This article looks at one way to hedge against inflation but, there are many other viable investments too. Although owning a commercial property is quite expensive, there are other ways to invest. Investing in REITS and publicly traded companies such as Cushman & Wakefield, JLL, and CBRE are great ways for common folk like ourselves to have some stake in commercial real estate.
The term, “REIT” stands for a real estate investment trust. A REIT is a company that owns, operates, or finances income-generating real estate. Often, they are publicly traded on the stock exchange. REIT’s generate a steady profit for investors and are a great way of allowing people to incorporate real estate investing into their brokerage account (Investopedia, Chen, 2022).
JLL, Cushman & Wakefield, and CBRE are three of the largest commercial real estate companies in the world, with hundreds of thousands of employees scattered across the globe. These investment management firms, which have been around for a century, provide commercial real estate services like debt, equity, and investment sales and advisory. These companies provide another great example of how an individual can get into real estate investing. Overall, there are so many ways to invest in real estate in 2022. Whether it be REIT’s, commercial real estate properties, stocks, or residential properties, there are many great ways to diversify your portfolio and get into the real estate game. And, it can be a great inflation hedge for a person or company.
High inflation is typically a time of economic hardship with little to no return on investments. However, during times like the present, commercial real estate investing is a great way to protect your investment and can often perform better during times of high inflation. This can be due to the fact that barriers to entry are higher, rents tend to increase with inflation, and people always need a place to live and work. As long as time has persisted, people have needed shelter in some form. This can be a home, hospital, apartment building, dormitory, or even your office building. As long as people are on this planet, real estate will be imperative. It could be smart to get involved in commercial real estate. Protect yourself from extreme inflationary pressures in the future exactly like the one the world is going through now.
References:
Chen, James. 2022 “Real Estate Investment Trusts (REITS)” Investopedia.
https://www.investopedia.com/terms/r/reit.asp
Severino, Ryan. 2022 “ The Price is High.” JLL.
https://www.us.jll.com/en/trends-and-insights/research/the-price-is-high
Bitner, David. 2021 “WHAT RISING INFLATION MEANS FOR CRE INVESTING.” Cushman
and Wakefield. https://www.cushmanwakefield.com/en/united-states/insights/what-rising-inflation-means-for-cre-investing
Guilford, Gwynn. 2022 “ U.S. Inflation Accelerated to 8.5% in March, Hitting Four-Decade
High.”
Banton, Caroline. 2021 “Interest Rate.” Investopedia.
https://www.investopedia.com/terms/i/interestrate.asp#toc-how-are-interest-rates-determined
Blake, Neil, Mowell, Matt, and Ren, Jing. 2021 “Estimating the Impact of Inflation on
Commercial Real Estate Returns.” CBRE. https://www.cbre.com/insights/articles/estimating-the-impact-of-inflation-on-commercial-real-estate-returns