As inflation increases, many investors look to income-generating CRE to serve as a barrier against devalued dollars
In December 2021, headlines announced a 7% inflation rate, marking the highest US price growth since 1982. Many analysts expect inflation to continue rising in 2022, and these increases, coupled with supply-chain disruptions and COVID variants, threaten to hold GDP growth to a projected 3.3% in 2022.
Today’s inflation rate is a significant change from what’s happened in the last few decades. In the previous 20 years, inflation has only topped 3% three times—and during that period, it was only over 2.5% three times as well. Inflation was a paltry 0.12% in 2015, and it was actually negative in 2009, at -0.36%.
Investors who have seen great returns over the longest bull market in history may need to adjust their strategies if they want to see continued growth in a high-inflation environment. And many analysts note that commercial real estate (CRE) can effectively hedge against rising prices.
Let’s review some inflation basics, followed by explaining how it affects investments and the interplay between inflation and CRE.
Inflation impacts consumer purchasing power and saving and investment decisions
Inflation reflects changes in the Consumer Price Index( CPI), a US Bureau of Labor Statistics metric that tracks “the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” Price increases indicate inflation, whereas the unusual case of declining prices means deflation. And disinflation is when “price inflation slows down temporarily.”
Obviously, if a sampling of the basket of goods used to calculate CPI costs $100 at the beginning of the year and inflation increases by 7%, those same goods cost $107 at the end of the year. And a consumer with a $100 bill in their wallet effectively has less than that—in terms of equivalent purchasing power—at year’s end.
To make up the difference, people must invest this money (or earn more). But investments need to keep pace with inflation and beat it to realize real returns.
How inflation affects various investments
Excessive inflation erodes the gains of many investments and turns some of them into losing vehicles. For example, someone who purchases a certificate of deposit (CD) with a fixed 1.5% annual rate of return sees their purchasing power erode and investment effectively devalue in a like period of 7% inflation.
This concern is one reason many analysts are now hesitant about fixed-income investments such as bonds, treasuries, and CDs. Many of these relatively conservative vehicles with more stable returns can’t keep up with the pace of inflation. But, of course, riskier vehicles like high-yield bonds may “have a larger cushion than their investment-grade counterparts when inflation is rising.”
The relationship between inflation and equities is more complicated but also concerning. While companies can adjust their prices and achieve revenue that keeps pace with inflation, this slows demand for their goods and services in an extended inflationary period. “Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a measure of economic equilibrium is reached.”
Nevertheless, some stocks can keep up with inflation, a characteristic that varies by company, industry, dividends issued, and other factors.
Again, investors in any vehicle that doesn’t beat inflation may see gains on paper, but they lose purchasing power. Thus, the search is on for investments that not only keep pace with inflation but deliver returns above and beyond its effects.
CRE is considered one of the go-to hedges against inflation
Several investment classes and areas are traditionally viewed as hedges against inflation’s effects, including inflation-indexed bonds and commodities like oil, gold, and food items, whose values are directly pegged to price increases. And real estate—particularly income-generating properties—is viewed as one of the most effective hedges against inflation. The reason is relatively simple: as prices rise, rents and often property values follow suit.
Nevertheless, CRE’s value in mitigating inflation depends on its cause and what else is happening in the economy. When inflation is driven by and accompanies economic growth, the situation benefits CRE returns. During these periods, vacancy rates are low, and rents are high. As a result, CRE investors increase their income, and the value of a property typically grows.
But if inflation involves an increase in the cost of goods accompanied by slow economic growth and high unemployment, it becomes “stagflation.” For instance, prolonged supply chain disruptions that increase prices long-term and dramatically slow sales and productivity could contribute to this scenario. At its worst, economic growth is nearly flat, low wages are out of sync with expenses, and unemployment is very high.
Unfortunately, this hurts real estate investing. Investors may not be able to find tenants or raise rents, severely inhibiting returns and increasing holding costs. However, CRE contracts can provide some protection against this scenario when they contain provisions for automatic rent increases every year. As long as the increases outpace inflation—and tenants stay or are locked in for a period—investors may ride out the economic storm.
These factors are all impacted by the supply of properties, of course. Some downturns make real estate more scarce, and the resulting high demand and limited supply lead to an increase in rents. In cases of oversupply, however—not a problem in today’s real estate market—landlords may not be able to pass along rent increases to their tenants.
Then, there is the impact of interest rates. Inflation typically sits between 2 and 3%. When it’s outside this range, the Federal Reserve will set monetary policies in an attempt to rein in price increases. If inflation is high and prolonged enough while accompanying rapid economic growth, the Fed increases interest rates, which it plans to do this year.
Increased interest rates push up CRE cap rates — the net operating income divided by the cost of the property. In one respect, this has a negative effect on CRE investors:
Historically, cap rates and interest rates have been proven to be highly correlated. Thus it is fair to assume that if all other variables remain the same, an increase in interest rates will increase cap rates and thereby decrease property value.
But again, the context of what else is going on in the economy makes all the difference:
In theory, stronger economic growth will lead to increased demand for space and higher rents, offsetting the rise in interest rates. On the development side, rising interest rates also increase the cost of construction as well as financing, generally resulting in less new product. With less available space saturating the market and steady demand from tenants, rents can increase, bolstering overall operating income, assuming operating expenses remain stable.
CRE and inflation takeaways in the current environment
High inflation is expected to continue much of this year, but the Federal Reserve expects it “will fall to 2.6 percent by the end of 2022 and 2.3 percent by the end of 2023.” In addition, wages are projected to rise and partially offset the effects, along with employment. To assess the potential impact of inflation on CRE, investors must account for all of these elements.
Overall, the economy is currently doing well, unemployment is low, property values and rents are increasing, and real estate inventory is pretty low (depending on the CRE sector). If this environment holds, history tells us that commercial real estate will serve as an excellent hedge against inflation. And when investors choose properties carefully with appropriate leverage and due diligence, CRE can be a wise investment in most economic cycles.
Morris Southeast Group has its fingers on the pulse of South Florida’s CRE market and offers insights to help our clients make ROI-based investment decisions. Contact Morris Southeast Group at 954.474.1776 today to learn more. You can also speak with Ken Morris directly at 954.240.4400 or kenmorris@morrissegroup.com.
