After ten years of consistent economic expansion and low-interest record rates, it is not surprising that inflation is starting to climb in the United States. In light of the likelihood that inflation will continue to rise, it is essential for commercial real estate investors to comprehend the causes of inflation, how it affects commercial real estate, and how to reduce inflation risk.
The Roots of Inflation and Its Influence on Real Estate Returns
There are two economic theories about the origins of inflation: cost-push and demand-pull. Demand-pull inflation occurs when relative demand for goods and services rises faster than supply. As a consequence of the 2008 reduction in interest rates by the Federal Reserve, the United States has seen little inflation during the previous decade. Lower interest rates give individuals and companies a greater incentive to borrow, resulting in increased spending and demand for products and services.
Increased demand for products and services pushes up prices, especially those related to commercial real estate ownership and operation. Typically, the economic expansion associated with demand-pull inflation positively affects commercial real estate; it increases demand for real estate, pushing up property prices and enabling owners to raise rents to offset increased property ownership expenses.
Cost-push inflation arises when the prices of raw materials required to produce goods or provide services rise. Cost-push inflation is always possible, but the prospective trade war and expanding list of freshly imposed import tariffs might trigger more cost-push inflation in the coming years. Cost-push inflation is usually the least desired kind since it may be more challenging to manage and result in slower economic development.
Developers and investors in commercial real estate may be directly exposed to higher construction costs due to steel and building material import levies. For instance, a 25% steel tax would increase the steel cost used to create the structural framework of commercial real estate assets.
Rapidly growing building prices might reduce demand for newly built real estate and prohibit the developer from selling the property at a higher price to cover their increased construction costs, assuming all other factors remain constant.
In contrast, investors already owning real estate might gain from inflation’s effect on development costs. The greater the expense to construct or replace an existing property, the greater the price the next buyer is prepared to pay for that property. For instance, an investor may be ready to pay $20 million for a 100-unit apartment complex that cost $10 million to construct in 1988.
The investor would be ready to pay $10 million more for the property than it cost 30 years ago since they would have to spend $25 million to build a comparable home. This concept stays true until the property price and related financing expenses prevent the investor from achieving positive cash flows or investment returns from the property.
Three Methods to Reduce Inflation Risk
- Lease Arrangement
Utilizing gross leases with spending pauses, increasing rents, and short-term leases may help offset increased operational and maintenance expenses in office and multifamily projects. Gross leases with expenditure stops compel the tenant to pay for costs that exceed a price cap established in the base year. These costs may include electricity, property taxes, insurance, and upkeep. Escalating rents are future rent increases stipulated at the outset of a lease. And short-term leases let the owner adjust rents yearly depending on market conditions, freshly completed upgrades, and inflation.
- Location, Location, Location
The significance of a location cannot be overemphasized. A property owner in a robust and economically resilient market will have a greater chance of achieving inflation-neutral profits than a property owner in a non-diverse market with low demand. A poor local market and real estate supply exceeding tenant demand make it difficult for owners to sustain steady occupancy, rent growth, tenant affordability, and investment returns.
Strong and economically stable economies with entry restrictions, a broad sector presence, and demonstrated growth will contribute to an oversupply of real estate demand.
- Diversifying the Capital Stack
Typically, a real estate capital stack comprises loans and equity. Diversifying real estate assets across both sides of the capital stack may assist in balancing out total returns during inflationary times since debt and equity investments tend to perform differently under varying economic situations. Debt investments with a fixed interest payment will underperform during inflationary times compared to periods of low or declining inflation. For instance, an investment in fixed-rate commercial real estate debt may provide yearly interest payments of 7%; but, if inflation increases from 2% to 4%, the investor’s actual rate of return will fall from 5% to 3%.
As described by the replacement cost and lease structure concepts, investments on the equity side of the capital stack may serve as a buffer against inflation by performing better during periods of inflation. In a commercial real estate portfolio, the mix of debt and equity investments may limit the adverse effects of inflation and balance risk and return.
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