Simply put, inflation is the decline in the purchasing power of a currency. If your dollars’ purchasing power decreases, you can buy fewer things with the same amount of money. As long as the cost of goods and services increases by no more than 2% each year, that is considered suitable for the economy since it stimulates demand, which in turn increases production and supply, creating healthy conditions for “competition” within the economy. Usually, when inflation rises at above-average rates without wage increases corresponding to that inflation, problems arise.
In February 2022, two key inflation indicators, the Consumer Price Index (CPI) and the Producer Price Index (PPI), reached 7.9% and 10.0%, respectively. In February 1980, when 14.8% of the CPI index increased, the increase marked the steepest yearly increase since The Great Inflation.
Several factors can cause inflation to affect the commercial real estate market (CRE).
Inflation Impacts Supply and Demand
It can be challenging to keep development costs low when the cost of purchasing and producing is rising. Can you recall when lumber prices skyrocketed to $1,500 per thousand board feet in May 2021? The combined effect of that and increasing labor costs can eventually slow down new construction and limit the future supply of real estate. This is one of the many causes why development projects are often considered high-risk investment opportunities. They are subject to shifting prices, timelines, labor shortages, supply chain issues, and permitting, among other topics.
New construction is often stunted (whatever the reasons are), which sometimes increases the value of existing inventory, especially if the property type is in high demand. In 2021, the industrial and multifamily asset classes mainly saw record-breaking price appreciation and cap rate compression due to increased demand and moderate overall supply.
The value of properties can rise more than twice as fast in markets with excessive demand than in periods of average inflation. If the cap rates remain relatively constant, the value of properties can increase even more.
Cash flows lose their real value as a result of inflation.
Operations costs such as maintenance, utilities, and insurance can also be affected by inflation. When the costs of maintaining a property increase, the cash flow can decrease. The dollar’s purchasing power is also a factor that can negatively impact cash flow, even if the flow remains constant. This can also affect investors’ returns. The inflation rate, for instance, may only make a dollar “worth” $0.93, or even $0.80, based on its earning potential.
As the dollar’s purchasing power falls, property owners who can increase their net operating income (NOI) by rising rents may be able to significantly boost their cash flows and, ultimately, their investor returns when the dollar’s purchasing power is lower.
Some asset types that move quickly to market when inflation rises are said to have “inflation resilience.”
Each asset type is affected differently by inflation
According to the CRE industry, inflation resiliency varies from asset class to asset class depending on whether property owners can adjust rental rates frequently and quickly.
An owner who signs a short-term lease is more likely to be able to move rents more quickly to keep pace with inflation. In theory, self-storage, hospitality, and multifamily properties tend to have the shortest lease terms. HOWEVER, an NNN asset that is fully leased on a long term with predetermined rent increases would lock the investment into a rigid rent schedule, leaving no room for it to increase its NOI or offset inflation. Typical examples would be traditional retailers like Starbucks and Walgreens or long-term industrial leases like those with Amazon (20-30 years).
The objective of adjusting the NOI is to increase a property’s cash flow to maintain parity with inflation, helping investors maintain a true sense of the value of future cash flows and, ultimately, maximizing their returns. In transitory periods of high inflation, many investors are usually well positioned due to the long-term appreciation of real estate assets.
Type of investment matters when it comes to real estate
The CRE sector does not provide the same inflation protection as other sectors. Private real estate investments with the highest returns, for instance, include apartment buildings and industrial properties. Due to its shorter-term leases, retail used to act as a great inflation guard, but since COVID-19, many retail businesses have moved online, which has changed the market.
The inflation that affects stock returns tends to help private real estate while hurting public real estate investment trusts, according to a recent whitepaper. The authors of this whitepaper contend that liquidity is a compounding factor in these situations. In general, private commercial real estate is less liquid, so it is better protected in times of economic crisis and inflation. In contrast, public REITs are typically more liquid and produce better returns when markets are strong.
The CRE sector can be a good hedge against inflation, but investors should ensure they are not undervaluing the property or missing out on future revenue.
Philly Home Investor is a full-service real estate investment company specializing in buying residential and commercial properties nationwide. We buy commercial properties and various different asset classes mainly specializing in warehouse and self-storage facilities.