How Does Commercial Real Estate Hedge Against Inflation?
In this blog we will unpack inflation, the causes of inflation, and how real estate hedges against inflation.
Inflation
What is Inflation?
Inflation is the rise in price level for goods and services. Inflation causes a decrease in purchasing power. If $5 can buy a hamburger today, and in one year from now that same burger is $6, then your $5 has lost purchasing power.
In other words, inflation is when the same amount of money does not go as far as it used to go.
As a consumer, you don’t have to study the economy to know if we are experiencing inflation; you notice it everywhere! Groceries, gas, etc.
How Is Inflation Measured?
Inflation is measured by comparing the cost of goods and services over time. There are several ways to measure inflation.
For example, one common measure is the Consumer Price Index (CPI) where the Bureau of Labor Statistics measures the change in price of a basket of goods and services consumed over time.
What Causes Inflation?
Serval factors contribute to inflation. Here are a few examples:
- Production Costs
When the price of goods and services rise due to increase costs (labor, materials, transportation costs), consumers now pay more for the same product.
- Demand
Consumers will pay more for the same product when there is an increase in demand for the commodity.
- Fiscal Policy
The government may cut taxes which increases discretionary income. The government may stimulate the economy by new infrastructure projects that provides jobs, increase the demand for goods, and causes more money to flow throughout the economy.
- Money Supply
An increase in the money supply will cause inflation.
Inflation Recently
In 2020, the inflation rate was 1.4%.
In 2021 the inflation rate jumped to 7%. Inflation declined slightly to 6.5% in 2022, and it is currently at 4.9% in 2023.
How Do I Protect My Money During Inflation?
With the recent inflation levels, one question is how do you protect your money from inflation?
You invest in assets that will appreciate over time.
How Does Commercial Real Estate Hedge Against Inflation?
Historically, commercial real estate fares well with inflation.
From 1978-2021, the unleveraged total rate of return for real estate was close to the cap rate plus inflation. I
n other words, over time, commercial real estate will generate a return on investment plus adjust for inflation.
How Does This Work?
There are a couple reasons why commercial real estate serves as a hedge against inflation. The main reason centers around one topic: Rents
Many properties are valued based on their current or potential net operating income. Due to inflation, rents will increase, so the value of the property increases.
In inflationary markets, an owner cannot purchase the same quantity of goods and services as they could previously with the annual income from a property, so the owner will raise rents.
Owners and tenants react to the supply and demand of inventory in a market.
During high inflation, the development of new buildings may slow due to the additional costs to develop.
Interest rates tend to rise with inflation, so the cost of borrowing is higher.
Inflation increases the cost of labor and materials, so it becomes less desirable to build additional inventory.
Coupled with the rise in costs, the supply in the market will tighten up, which will increase prices of existing buildings.
What About The Owner’s Costs?
So an owner raises rents due to inflation. Wouldn’t the cost of owning a property rise as well? Yes and no.
Some of the owner’s costs are fixed costs, at least in the short term.
For example, an owner may own a property without debt or be locked into a low interest rate, so their cost of borrowing will stay the same.
Other costs, such as maintenance costs may increase, but the increase in rent will likely outweigh the extra operating expenses. And in many cases, those expenses are passed directly to the tenant.
Long Term VS Short Term Inflation Hedge
For the most part, commercial real estate is a good long term hedge against inflation.
One reason commercial real estate fares better in the long term to hedge against inflation is because most times rents cannot increase over night.
Commercial real estate is often discussed as a single topic when in reality, it is very broad and diverse.
Many leases may be long term with few to no rent escalations in a lease.
It may take several years until the end of a lease term for an owner to raise rents to match market rents and keep up with inflation.
Some asset classes, such as self storage or multi family, can adjust to price increases within a couple weeks.
Conclusion
As inflation decreases the purchasing power of a dollar, it’s important to invest money in assets that will appreciate and hedge against inflation.
Historically, in the long term, commercial real estate fares well in inflationary markets. This is due to the fact that rents can be raised over time to keep up with market demand and inflation.
In times of high inflation, existing buildings are often more cost effective than new development which increases the demand for existing commercial real estate.
In the end, commercial real estate is a broad category. Some asset classes will adjust more quickly and easily to inflation than others.
Did you find this blog helpful? Would you like to discuss commercial real estate? Let’s connect!
Emma McDaniel
864-576-4660
Sources
Current US Inflation Rates: 2000-2023 (usinflationcalculator.com)
What Causes Inflation? (investopedia.com)
4 ways to measure inflation – Marketplace
Inflation and Commercial Real Estate: What You Need to Know (crowdstreet.com)
How Inflation and Rising Interest Rates Impact Commercial Real Estate (metlife.com)
What History Teaches Us About Inflation And Commercial Real Estate (forbes.com)
Inflation and Commercial Real Estate: What You Need to Know (crowdstreet.com)
