Inflation is a crucial factor in any economy. Inflation rate changes are frequently interpreted as a precursor to oncoming change and the conclusion of an economic cycle. A sharp increase in inflation can have a big impact on investors’ portfolios, especially if they don’t know how to deal with it.
It is self-evident that inflation and commercial real estate pricing are inextricably linked. An increase in federal interest rates directly impacts commercial real estate valuations and is sometimes used as a “cure” for inflation.
Interest rates were expected to rise, but economists were taken aback by the possibility of three rate hikes between now and 2022. Additionally, speculation suggests that prices will rise in 2023 and 2024.
To combat rapidly rising inflationary pressures, primarily due to supply chain disruptions, the Federal Reserve plans to raise interest rates aggressively. Despite inflation reaching its highest level in four decades, some investors remain skeptical of real estate’s ability to keep prices from rising.
Investing in commercial real estate is a proven way to hedge against inflation. Leases allow for rent increases in line with consumer price changes, making it a cash-flowing asset.
The Concept of Inflation
This is when the purchasing power of a currency depreciates due to inflation. It occurs when the cost of goods and services rises over time in a particular market, industry, or country. Property owners establish CAM charges for space maintenance in the real estate industry and gradually increase them to account for inflation.
Inflation and Commercial Real Estate Relationships
The relationship between the operation of commercial real estate properties and inflation is versatile. Prices and incomes tend to rise when inflation increases. Because most commercial real estate values are based on net earnings, rents and expenses should rise or fall in tandem with inflation. Frequently, expenses often outpace income.
Inflationary Effects on Commercial Real Estate
Like other physical assets, commercial real estate (CRE) appreciates in lockstep with inflation.
Opportunity and Risk for Investors
Inflationary pressures can be beneficial or harmful to real estate, but they can also present possibilities for investors. Real estate is frequently viewed as a highly effective hedge against rising costs, with assets that benefit from fixed annual rental escalations that effectively offset inflation.
The disadvantage for investors is that the traditional response to inflation increases the cost of money and the cost of borrowing. Because inflation devalues currencies, most lenders are forced to raise interest rates even higher, making loans even more expensive for those who need them.
Growth In Property Value
Inflation can lead to increased property values, which is good news for investors. Inflationary pressures, for example, will raise the cost of construction supplies. With greater borrowing rates and higher building expenses, new construction can become less appealing, especially since these higher costs are often passed on to occupiers. Existing property prices may rise significantly if the supply of new buildings is decreased.
Boost Rental Income
Inflation typically leads to increased rental values, with increased mortgage costs causing more people to choose to rent rather than buy their own homes. Due to the increased demand for rental properties and the influx of new tenants, landlords are typically forced to raise their rents.
Low Inflation Risk
Commercial real estate appears less at risk from inflation over time than it does from low growth. However, governments should make changes sooner rather than later to prevent a negative impact on consumer and industry confidence. In addition, the real estate business should be wary of the potential for inflation to cause chaos and plan accordingly.
The economic repercussions of COVID-19 will take decades to materialize fully. The current low rates create the ideal opportunity for borrowing, but the massive stimulus governments provide worldwide may lead to a rise in inflation.
Bottom Line
The benefits of the stimulus currently outweigh the risks of future problems. Nevertheless, with debt levels at an all-time high, the balance between the two will become increasingly difficult. Regardless of the outcome, the potential of the real estate industry to balance inflation through rental value increases makes it a more appealing asset class than bonds or equities.
There’s still a lot to learn about how inflation affects the economy and commercial real estate. One reason is that performance has so many variables. Another factor is that times of high inflation have been uncommon. The last time there was inflation similar to what we see today was a long time ago, when the economy and macroeconomic policy were very different, so some of the lessons learned then may no longer be applicable now.
Property managers everywhere are looking for ways to optimize their processes and create accurate budgets in a rapidly changing real estate market. One tool that can help track the changes in property prices and the impact of inflation is UnitConnect commercial real estate software.
