Inflation is a macroeconomic force that impacts commercial real estate investments up and down the value chain. Increasing prices for goods and services affect operations while riding price levels reduce the purchasing power of investment returns. On balance, investors commonly incorporate commercial real estate into their broader portfolio to hedge various risks, including inflation.
Inflation is one of three targets within the Federal Reserve (the “Fed”) mandate to maintain a healthy economy. The other two are unemployment and economic stability. The Fed uses different techniques to affect changes in these targets, but generally, interest rate manipulation is their most common tool.
Lower interest rates along with robust economic growth for a prolonged period pumps more cash into the economy. Supply and demand for money take over from there. More money on the system reduces its purchasing power because there’s little scarcity.
1. Lease Reset
Commercial real estate leases became more concerned with inflation during a tumultuous macroeconomic climate in the 1970s and 1980s. During that time, high inflation ate away the purchasing power of a fixed return from CRE leases. A dollar of rent was worth only $0,90 after a year of 10% inflation.
CRE investors demanded change.
To reduce inflation’s impact on commercial real estate investments, owners wrote in lease adjustments to account for accumulated inflation. As a result, most tenants start with a base initial rental rate, and every three to five years, the rental rate adjusts based on increases in the level of consumer prices – the Consumer Price Index (CPI).
These CPI adjustments ensure that inflation doesn’t erode Investment returns.
2. New Leases
Local markets set lease rates based on various factors, including supply and demand of comparable spaces. The general level of inflation impacts new commercial real estate leases also but almost indirectly.
Higher economic activity usually ties to higher inflation levels. That means demand for space is surging in all asset classes. Think, a rising tide lifts all ships.
A new lease signed in good times will benefit from top-of-the-market rent for years. However, a bottom-of-the-market lease will be stuck there for just as long.
High-velocity leasing assets take advantage of increasing price levels the best. For example, hotels reprice daily based on nightly leases or shopping centers with a good bit of churn bring in new tenants frequently.
3. Expenses
Your vendors will also take advantage of rising price levels. Just like you raise rents for new tenants, vendors typically reset prices annually.
Prices on some contracts are stickier than others.
Your asset class and investment strategy will determine the structure of vendor agreements. Generally, you’re in a good place to roll the dice on unpredictable price adjustments in a high-velocity leasing asset because it adjusts quickly with inflation. However, lower velocity properties, like office and industrial, may do better with predictable price increases built into the agreement.
4. Property Values
The first three inflation considerations were operationally focused, but these next few step up to the asset management level.
Many factors combine to impact property values. Market dynamics include interest rates, the ratio of buyers to sellers, and profitability expectations within your niche. Let’s look at a few ways these factors affect value.
Debt amplifies your investment returns by laying off lower risk portions of the capital stack on someone else for a fixed payment. Therefore, your ability to stretch on price to acquire an asset increases as interest rates decrease because the lower risk financing is more affordable.
Credit availability also impacts who plays in the market. More buyers relative to sellers drives prices up. Interest rates and strong credit markets are two levers that the Fed uses to juice the economy, which drives up inflation.
Profitability expectations are tied to revenue increases relative to expense inflation. Labor is usually the biggest consideration here because it’s difficult to control in the same way you can negotiate contacts with vendors. Therefore, more labor-intensive asset classes have higher variability and risk in their asset pricing.
It would be nice to have a simple, elegant, unified model to predict how inflation impacts commercial real estate property values. Unfortunately, there are many moving parts. Just these three considerations play together in different ways across asset classes.
5. Real Interest Rate
Economists look at price levels in two ways. Nominal price levels are the actual dollar transaction value of an asset. Real price levels strip out inflation from the nominal amount to compare value changes from one period to the next.
Interest rates represent the price for money.
In a simplification of the Fisher Equation, nominal interest rates (the rate you see quoted) equals the real interest rate plus the inflation rate. You can use this to back out the real interest rate using known information – nominal rate and inflation. For example, a 5.0% quoted interest rate minus a 2.0% inflation rate equals a 3.0% real interest rate.
This concept doesn’t shock and amaze when first introduced, but you’ll be amazed when you start looking through this lens at the real cost of capital. Just imagine, prevailing interest rates of 2.0% when inflation is also 2.0% (or more) results in free money (or better).
6. Real Returns
Commercial real estate investors sit on the other side of that Fisher Equation, too.
You’ll hear a lot about “beating inflation” if you hang around investors enough. Inflation is the return threshold where your investments begin to become profitable. You maintain the purchasing power of your initial investment as long as your rate of return is greater than inflation.
Real return on investment equals the nominal return minus inflation. In this case, the nominal return is the actual cash distributed divided by your initial investment. Therefore, a nominal rate of return of 16.0% minutes an inflation rate of 2.0% results in a real return of 12.0%.
As we established, inflation impacts commercial real estate investments on both the operational and investment levels. Your real return should do well so long as you optimize for both.