How Does Inflation Impact Commercial Real Estate?
If you’re considering investing in a crowdfunded commercial real estate deal, or currently hold a stake in a crowdfunded deal, it’s important to understand the relationship between macroeconomic influences and commercial real estate (CRE).
One of the major macroeconomic influences on CRE valuations and profits for investors is inflation. Put simply, inflation is the rate at which prices for goods and services rise over time. But it’s important to realize that there are different types of inflation, with differing effects on CRE prices and investment performance. Let’s examine the main varieties and their impact on CRE.
Understanding The Varieties of Inflation: Growth-Driven Inflation
As it relates to CRE profits, there are two primary kinds of inflation to understand and be mindful of. The first is growth-driven inflation.
Growth-driven inflation, as you can probably guess, is inflation that’s fueled by an economy that’s experiencing a period of strong growth. Employment is on the rise, which means the currency pool has expanded because more people have more money to spend on goods and services.
An economy that’s characterized by a period of growth-driven inflation is favorable to CRE investing for a few reasons. The first is rising rent prices. With more individuals and businesses competing for the same space in light of a booming economy, the value of that space (its rental cost) predictably increases.
The second reason that growth-driven inflation is good for CRE is that vacancies decrease. This is because strong economic conditions will lead to more individuals and businesses competing for the same limited amount of rental space for their companies.
The third reason is that incomes rise during periods of strong economic growth. This is good news for CRE investors in at least 2 ways. The first is related to the increasing rental costs that we discussed above. Widespread increases in income will make it much easier for CRE tenants to handle upticks in the cost of their rent. And because tenants can handle a slight increase in rent due to the higher revenue they’re likely achieving, vacancy levels in commercial properties will usually stay low during times of growth-fueled inflation.
All in all, if inflation comes as a result of a strong economy, that’s usually a predictor of strong CRE performance. But there’s another type of inflation to keep in mind as well.
Understanding the Varieties of Inflation: Stagflation
The word “stagflation” was coined in 1965 by Iain Macleod, a British politician. Essentially, it’s a combination of rapidly rising costs of goods and services with high unemployment and low national productivity.
Any single one of these three economic indicators does not point to stagflation per se. It’s when all 3 occur in tandem that stagflation occurs, because the costs of goods and services are rapidly climbing at the exact same time as employment and productivity have stalled. This creates a stagnant economy.
This variety of inflation negatively impacts CRE performance and valuations. Even if commercial landlords raise their rent to keep step with the climbing costs associated with stagflation, their commercial tenants will likely not be able to keep up due to the declining profits they’re likely experiencing.
Predictably, then, stagflation results in higher vacancies. This harms the return levels of CRE properties because less rent is being generated month over month. It also harms CRE valuations overall, because if the owner of a building is looking to sell it during a stagflation period, they will most likely be forced to lower their price to reflect what the economically depressed market will bear.
The core reason behind the second point above is that CRE owners usually leverage borrowed money to purchase assets. The Fed tends to raise interest rates during inflationary periods, making it more expensive to borrow money, and this typically results in fewer people looking to purchase existing CRE assets.
Commercial Real Estate As A Hedge Against Inflation
It’s also important to realize that CRE serves as a very effective hedge against inflation in general, provided it does not get out of control or veer into the realm of stagflation. There are 2 primary mechanisms behind this. The first has to do with CRE as an income-producing asset, and the second deals with the impact of inflation on core valuations.
The first (and more self-explanatory) reason is that commercial landlords can raise their rents in lockstep with inflation. So if you hold partial ownership of a CRE asset through a crowdfunded deal, this should help you keep your profits steady when compared to the overall negative impact that inflation usually has on other asset classes.
The second reason has to do with inflation’s impact on the basic components of CRE: construction materials and labor. Inflation raises the cost of goods and services across the board, and these are no exception. Rising costs for construction materials and labor will result in a supply crunch for CRE, as new projects become prohibitively expensive and thus become much less common due to these considerations and higher interest rates on borrowed capital.
If you own a stake in an existing CRE building, this is good news because the increased scarcity in buildings will lead to both an increase in rent due to less space being available for businesses overall, as well as an overall increase in the building’s value for the same reason. Existing assets will grow increasingly valuable, as the conditions for production become less and less favorable due to hiked interest rates.
Inflation has become a somewhat feared concept to most people, especially investors. But with a sophisticated investment strategy, you can do more than simply preserve and protect your wealth during inflationary periods: you can actively profit from them.
As we’ve discussed, CRE offers a unique chance to capitalize on inflationary trends. You’ll still need to monitor the macroeconomic horizon for signs of stagflation, but by holding a crowdfunded stake in a CRE investment, you can achieve smooth returns during times when other investors are losing their shirts in the financial markets.