by Rachel L. Richardson

Note: some linked articles may be behind subscription paywalls.

With inflation reaching a higher-than-expected
8.3% year-over-year rate in August, more investors are discussing commercial real estate (CRE) as a hedge against inflation. The consumer price index (CPI) increased by 0.1% in August, while the core CPI (which omits the more volatile food and energy indexes) increased by 0.6%, making greater gains than it had in July. To measure inflation, the Federal Reserve (the Fed) prefers to use the personal consumption expenditures (PCE) index, which has also posted year-over-year gains, in the amount of 6.3% as of July. To curb inflation, the Fed has instigated five rate increases in 2022 as of September 21, with the last three at 75 basis points each.

Predictions

During their August meeting in Jackson Hole, Wyoming, Fed Chair Jerome Powell announced an intent to continue an aggressive bid to reduce inflation, even as such measures “bring some pain to households and businesses,” arguing that “failure to restore price stability would mean far greater pain.” At the most recent rate increase, Fed press release notes the Committee “anticipates that ongoing increases in the target [rate] range will be appropriate.”

Executive Summary

  • CPI shows inflation at 8.3% year-over-year as of August.
  • Economists expect sustained inflation through the year and a return to the target 2.0% by 2025.
  • The impact of inflation on CRE will vary by asset type and location.
  • Inflation will affect CRE participants (brokers, buyers, owners, tenants) in different ways.
  • As the markets shift in response to inflation and other economic factors, specialized and local knowledge will remain key to informed investment decisions.
In her September speech, Lael Brainard, Vice Chair of the Board of Governors of the Federal Reserve System, echoed this sentiment, saying the Fed has “expeditiously raised the policy rate to the peak of the previous cycle, and the policy rate will need to rise further” to bring inflation down, and to “maintain anchored inflation expectations and price stability.”


Before the latest increase,
Bloomberg’s survey of economists revealed an expectation that, after a 75-basis-point increase in September, the Fed would taper off to 50 basis points in November. The same survey projected PCE inflation will decrease to 2.6% in 2023 and reach the Fed’s goal of 2.0% by 2025. Predicting a more aggressive approach, Goldman Sachs economists expect another 75-basis-point hike in November, 50 basis points in December and 25 next February, for a peak funds rate of 4.5%–4.75%.

The Fed currently faces headwinds in the form of ongoing supply chain issues, geopolitical turmoil, and a tight labor market.

Inflation and CRE

With the stock markets sustaining fresh shocks amid what seasoned investors are calling classic bear market rallies, investors continue to turn to CRE as a hedge against inflation since it can allow for long-term, steady income, including lease terms that may adjust to CPI.

A hesitancy to overbuild has, in the past decades, generally led to greater demand than supply. Lately, the volume of new construction has rebounded, reaching a
14-year high in July, and while the August figures declined slightly from the month prior, they still represented a 14% year-over-year increase. With the rise in interest rates and weaker economic conditions, new construction starts are expected to slow in the coming months, once again placing upward pressure on the values of existing inventory.
For these reasons, it may not be surprising that the volume of CRE investments
rose 10% year-over-year in the U.S. Additionally, foreign investments in U.S. CRE have increased by 13% this year. Clearly, those with the liquidity continue to seek favorably positioned assets.
How well an asset is positioned to withstand inflationary periods, though, depends on several factors: the asset type, its location, and the timeframe of the investment.

TIME

As a hedge against inflation CRE investments are most beneficial longer term—in the range of five years or more—ideally as part of a larger and varied portfolio; while as a short-term investment, CRE is often misunderstood. CRE can be susceptible to inflation shocks and increases to operating expenses that may not be able to be passed off to a tenant or recouped in rent increases, depending on the asset class and location. While it can be a solid investment strategy in times of high inflation, it is important for investors to “ensure they don’t undervalue the investment or fail to capture future revenue.” And, as in other asset types, maintaining a diverse portfolio remains a strategic move.

LOCATION

Because of their fixed locations, real estate investments benefit in areas experiencing growth in demographics and job opportunities, which in turn encourage demand and economic opportunity. The first year of the pandemic revealed a shift in population from some of the most populous cities (on the East and West Coasts) to less populated areas, particularly in the South and West. Some cities experienced at or over 5% population increases over the year prior (period ending July 1, 2021). At the state or district level, both DC and New York experienced the greatest percent declines over this timeframe (-2.9% and -1.6%, respectively). Meanwhile, a swath in the Rocky Mountains posted the greatest increases (from Arizona at 1.4%, Montana and Utah at 1.7% each, and Idaho at a remarkable 2.9%).

Pointing to insulating, regional growth factors, an article by Commercial Property Executive (CPE) highlights the lower cost of living and number of skilled laborers in the Midwest; population growth in the Sun Belt; and, in the Northeast, the scarcity of infill locations and lengthy entitlement processes that keep demand running hot.

TYPE

Since the impact of inflation on each of the main CRE property types—multifamily, industrial, office, retail, and hospitality—is varied enough to warrant its own post (and truly, each could warrant a post on its own) we’ll cover these in Part 2. There we’ll summarize key trends for each property type, touching on aspects like development, supply and demand trends, lease structures, and revenues.

Inflation and CRE participants

For developers, rising interest rates and cost of construction materials, scarcity due to supply chain issues and labor shortages may make some projects unfeasible, which in turn places an upward value pressure on previously developed space. Still, in certain sectors and locations, constrained supply of previously developed properties, combined with high demand, has allowed projects to continue to “pencil out.”

With interest rates on the rise, some buyers may be priced out of the market, or experience less favorably leveraged financing. Studies have indicated that that private real estate investors, because of the largely illiquid nature of their investments, are likely to weather inflation better than public REITs, which hold more liquid assets.

Owners
of CRE should benefit from having locked in a previous, lower interest rate, while refinancing and renovation will likely taper off in the coming months. For leased properties, these lower operational costs may allow for more attractive tenant lease agreements, maintaining occupancy more easily. Since development will likely be dampened, there will be more competition for existing properties, for sale or lease, which will positively affect property values. Some owners may be able to pass along some operational costs to their tenants, favoring leases that are triple net, shorter-term, or leases that adjust to CPI.

With uncertainty surrounding future costs and revenues,
tenants will likely favor longer-term leases that lock in lower, fixed rate increases in the future. In spaces like retail sales, tenants may seek flexible leases that adjust to their revenues, a flexibility that may benefit both the tenant and the landlord.

Inflation and valuation

As inflation, monetary policy, and other factors effect a shift in the landscape of CRE, unbiased assessment of real property investments is even more vital for informed decision-making and asset management. From market rent or feasibility studies to portfolio valuation or highest and best use analyses, appraisal professionals use data-driven, specialized assessments to help investors knowledgeably approach their current (or intended) assets. In Valbridge Property Advisors, CRE owners and investors have access to experts across the nation, each with local expertise, who leverage their datasets through cutting-edge technology, providing true valuation independence.

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