Inflation and Its Impact on Commercial Real Estate
If you are a real estate owner or are planning to diversify your investment portfolio, the rising inflation rate should be a critical point to consider when comparing assets. The annual inflation rate hit 6.2% in October, as measured by the Consumer Price Index (CPI), making it the highest YoY (year-over-year) increase in three decades. Also, November marked the ninth consecutive month that inflation has stayed above the 2% goal of the Federal Reserve.
But what does all this mean? How does it affect our economy daily? More specifically, what is inflation's impact on commercial real estate? Is it true that housing prices always go up, even in this economic climate? Follow along to learn more about inflation and the effects it can have on real estate.
What exactly is inflation?
Before understanding inflation, it can help to have an idea of what Purchasing Power is: the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. It's also known as the buying power a currency has.
Inflation is the decrease of a currency's purchasing power. It happens because the prices of goods and services rise over a period of time across an entire market or industry, or even the whole country. Usually, inflation hits the energy, financial, and utility sectors the hardest, but that doesn't mean other sectors can´t be affected too.
Why does this happen? The most common answer among economists is that sustained inflation occurs when a nation's money supply growth outpaces economic growth. If the money supply grows too quickly, the money starts losing its power. After all the economic ups and downs brought by the COVID- 19 pandemic (central banks lowering interest rates to rock-bottom levels, supply-chain bottlenecks, and volatile consumer spending behavior) it's not surprising we are facing a period of inflation. Some inflation can be seen as a normal step in a healthy economic cycle—that's why the Federal Reserve's goal is to keep it at 2%. However, if it gets out of hand, it can have destructive effects on a country's economy.
What impact does inflation have on commercial real estate?
Inflation can have a bright side—and in the case of real estate, it may be easier to find. The value of tangible assets, like property or stocked commodities, tends to rise in case of inflation. This means people can sell them at higher prices than usual.
However, you have to have in mind that most people will probably not be in the position to buy at all. The housing market prices have been increasing for a while now and it doesn't seem they are going down anytime soon.
It's a delicate balance which is why any person who wants to invest in or buy any real estate has to plan in case of inflation to avoid a heavy impact on their portfolio.
These are some of the effects inflation can have on commercial real estate:
Property values go up: If inflation makes the prices of materials increase, so do the costs of construction. In that chain of events, new homes become more expensive. This is good for people with pre-own houses because people will start looking at them as an alternative to the new, higher price ones.
The rental prices increase: When the pricing of housing goes up, people start looking for places to rent. This creates higher demand, which incentives landlords to increase their prices.
The selling prices increase: Selling during an inflation period can bring you a lot of profit given the rise in prices. However, there usually will be a lot of bidding wars and accelerated buying processes, and “as if” situations. Buyers need to know when and who to sell to if they want to make the best out of the deal.
Loans are harder to obtain: With prices elevating and the currency losing its purchasing power, lenders tend to raise their interest rates. This makes people in search of a property wary of taking the loans they need to buy it.
Is real estate an inflation-hedged asset?
Historically, real estate has been considered as a hedge against inflation. This means that it's an asset that isn’t subject to wild fluctuations or that generally moves against the market. Home value tends to keep up with inflation. Inflation can also benefit those with debt since it lowers the loan-to-value of any mortgage debt as home prices rise. Rent, however, is more likely to go up since it is more unpredictable than a mortgage. This benefits real estate investors who are earning income from rental properties.
These are some of the ways you can turn your real estate into inflation-hedged assets:
Appreciation: An increase in property value is called appreciation, this relies on diverse factors (location, age & condition of the property, supply and demand, interest rates, etc). The appreciation of your property can counterbalance inflation to a certain degree. Choosing wisely when it comes to your property can impact your investment positively. Research what areas in your city are growing and overall real estate trends.
Investing in multifamily properties: One of the best ways to use real estate as a hedge against inflation is investing in multifamily properties. Apartments are always in demand and secure you a bigger and more consistent cash flow than single units. Besides, with the prices of homes going up more people search for rentals.
Expense reimbursements: If you have a property, you can add this component to your lease policies. Your tenants will help you absorb some of the extra expenses caused by inflation.
Try real estate investment trusts (REITs): These provide investment opportunities in the world of real estate without having to buy a property. They have a record of reliable and growing dividends and total return performance. They are worth looking into if you want to dip your toes in the market.
Overall, inflation doesn’t always mean bad news. Historically, the value of real estate will go up with inflation. For those in commercial real estate, this asset can act as a good hedge because it generates cash flow. However, not all real estate properties can be a hedge against inflation. It's always essential to take your time researching properties or seeking out experts that can help you make informed decisions.