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The past few years have presented challenges for global investors as the economy entered a volatile and turbulent period due to mounting inflation, increased interest rates, and other unanticipated factors. Under such circumstances, some invariably wonder whether there will be a repeat of the oppressive inflation rates of the 1980s, and if so, what the most effective methods are for hedging against it.
Finding assets providing appreciation, income, or a combination of the two to help offset a decline in purchasing power has become a focus of many global investors.
Though many asset classes can be used to diversify a portfolio and protect against increasing inflation, commercial real estate is compelling due to its ability to increase in value over a long-term holding period and generate income. The value in CRE is intrinsic, fundamental, and tangible– as opposed to soft assets like stocks and bonds.
Let's take a closer look at the factors investors want to know when considering investing in commercial real estate as a hedge against inflation.
One of the major benefits of commercial properties as a hedge against inflation is that they can generate rental income which helps absorb inflation. Beyond that, as a real asset, CRE investors can benefit from rising costs thanks to owning a tangible, appreciating property.
Additionally, expense increases commonly accompanying inflation can often be passed on to tenants either through rental rate increases or lease terms obligating tenants to be responsible for certain expenses and maintenance costs. Overall, property values have historically proven to keep up or even outpace inflation, meaning purchasing power doesn’t erode over the long-term.
Commercial real estate has historically demonstrated strong performance through multiple economic cycles. Since 1978, commercial real estate in the U.S. outperformed inflation more than 87% of the time, including the high inflation periods of the late 70s and early 80s.
During inflationary periods, CRE has historically maintained or increased its value as well as its overall performance. For this reason, it has long been considered a stable long-term investment. Thanks to the ability for owners to increase rental rates to compensate for increased demands or higher operating expenses, it's no surprise that there has been renewed interest in the CRE sector during this time of rising inflation.
Of course, the devil is always in the details, as several factors can influence a particular asset’s ability to hedge inflation, including lease duration, debt type, cap rate movement, and supply and demand drivers.
Many commercial real estate investment characteristics make it a useful hedge against inflation. Perhaps the most important of these is the way leases are structured, where step-ups are often built-into the rent during the lease's term.
Even when this isn't the case, leases can also stipulate the creation of an altogether new rent contract when the lease is renewed. Even if the local market doesn't support a significant price increase, it is still likely that the price adjustment in rent will catch up to inflation. In general, long-term leases will not catch up to inflation nearly as quickly as shorter-term leases, so the concepts of duration and effective lease management are key variables.
Further inflationary protection can be provided through the assignment of expenses. Depending the type of lease utilized, an individual might pass along all or many expenses through to tenants. Other leases will only pass through some of the common area maintenance expenses to tenants.
Additionally, there are two avenues where property valuation is impacted by inflation. The first is capitalization rates, and the second is NOI growth.
Property value is largely established through NOI to the extent that the flow of net operating income has inflation protection embedded within it in a way that doesn't specifically affect cap rates. At the same time, though, inflation impacts market cap rates because of its correlation with long term interest rates.
Higher interest rates create negative pressure on property values, but this will also boosts NOI growth due to strengthening economic growth. Property values will be more likely to increase due to interest rates rising with a stronger NOI growth response to inflation. This represents the core foundation of commercial real estate’s hedging abilities.
Beyond granular factors such as what we’ve been discussing, it's important to recognize the nature of real estate, best characterized as a hard asset, which lies at the core of understanding its ability to hedge against inflation. Land typically appreciates over time, particularly if the way it is utilized (measured by economic activity and population density) expands to new uses.
With greater economic activity and land-use density in an area experiencing demographic growth, most of the time land value accordingly increases.
Of course, the physical structure must also be considered. The perceived value of an existing property is partly influenced by the cost of building replacement. As construction is a process involving a fixed location, specific materials, and intensive labor inputs, accelerated inflation rates can significantly increase replacement costs, which in turn impacts property valuation.
The relationship between a property's replacement value and its valuation is clearly illustrated in the years since the start of the pandemic, where supply chain disruptions and labor shortages significantly increased the cost of construction.
The initial conditions of a local real estate market dictates the degree to which inflation influences rental rates. Fluctuations in rent typically change with an imbalance between supply and demand, creating a non-linear change over time. This, in combination with the relationship between supply and demand can result in increased rents over time. Thus, we see the effectiveness of using commercial real estate as a hedge against inflation is maximized during periods of increased demand or reduced supply. Conversely, a period of excess supply or reduced demand makes it a less effective hedge.
Ultimately, rent growth generally keeps pace with inflation if demand and supply are relatively equal. Periods of low vacancy rates driven by high demand or low supply create a scenario where commercial real estate acts as a potent hedge against inflation, while rent increases can fall short of the pace of inflation if vacancy rates are higher than average.
Commercial real estate’s ability to function as an effective inflation hedge given current market conditions is supported by low vacancy rates, particularly in the industrial and multi-family sectors. Post-pandemic, tenant side demand remains relatively strong in most CRE segments with rent growth continuing to outpace inflation, save for some segments of retail as well as the office sector.
During this period of elevated inflation, shorter-term lease lengths characterizing sectors such as hospitality and multi-tenant, will typically provide needed protection from inflation.
Ultimately, there is significant potential associated with using commercial real estate as an inflationary hedging instrument. However, this relies on strong underlying tenant demand in combination with the ability to adjust lease rates or pass-through expenses.
If the future were to hold a scenario where the rate of inflation and purchasing power continue in an upward trajectory hand in hand, inflation is less of a concern. The reality is that the only way to fight inflation and get on the right side of it is to increase earnings.
It’s precisely this reason that many investors use real estate as a hedge against inflation. As a point of review, consider the following factors we have discussed:
As mentioned above, in the post-pandemic period we now find ourselves in, some sectors are currently performing better than others. While office buildings and some retail spaces struggle, apartments and industrial properties have low vacancy rates and are booming.
This doesn’t necessarily suggest retail or office spaces, are currently a bad buy. Real estate values are highly localized; thus, we should avoid making broad brush generalizations about one property’s ability to act as an inflationary hedge without thoroughly considering location and other key variables. The pandemic provided a stark reminder of just how quickly an unprecedented and unexpected global event can send real estate values plummeting. The take-away? Investors must remain vigilant and mindful of a wide array of unanticipated circumstances that can send shockwaves, and how these can affect value.
When considering the pandemic’s impact and the requisite fallout on different classes of commercial property, some innovative and visionary thinking is required. For inspiration and information about how different cities are coming up with creative solutions to the new world of work, check out our #RethinkTheNews pieces on repurposing commercial real estate assets and the future of real estate in downtown Boston.
Commercial real estate is a long-term investment requiring time to mature, and therefore, should not be viewed as a short-term hedge against inflation.
The frequently cited maxim "time in the market is better than timing the market," suggests investors needn’t be obsessively attuned to purchasing a property when the market is at its place lowest without thoroughly considering an array of other equally important factors at play.
When considering the potential usefulness of CRE as an inflationary hedge, an investor must consider they are always inherently weighing asset classes against one another, assuming their funds will be invested in one place or another. Despite the inherent risks associated with investing in CRE for inflationary protection, its hard asset quality retains a steadiness and greater predictability quality than corporate stocks and bonds.
In volatile times, investors need to monitor the impact of stock market drops and how they affect real estate value. This must be balanced by the many lessons learned through the retail and office sectors about how a global event can impact the strength and health of particular real asset investments.
Regardless of how fervently anyone insists they know what happens next, none of us can predict the future with absolute certainty. Forecasting investment options whether they involve real estate or other financial instruments is an imperfect science often prone to subjectivity and gut instinct. Despite this, diversifying an investment portfolio is always a sound strategy as it can help mitigate and control investment risks associated with events such as recession or mounting inflation.
In today’s current economic climate, it's more important than ever to quickly be able to access all relevant data and financial information associated with your property portfolio to ensure the ability to make quick, informed decisions that support the portfolio’s overall health. Helping one’s team save time and reduce risk was a main driving factor that went into the creation of itamlink.
It is a powerful, yet user-friendly software solution created for owners and occupiers of multi-property portfolios. Users can maximize efficiency and improve their team's collaborative capabilities through a central data repository and seamless integrations. By utilizing the power of automation, they can also streamline workflows and ensure data accuracy.
itamlink is more than just a property tax management software - it allows users to review, analyze, and assess trend values to help quickly identify errors or anomalies; track, review, approve, and submit bills with ease; easily review and manipulate data to gain access to valuable insights, and so much more.
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