How Does Inflation Affect Commercial Real Estate?

Commercial real estate is widely considered to be a good long-term hedge against inflation, as owners may benefit from stable income and the ability to increase rent.

Inflation in the U.S. has risen to levels we’ve not seen since the 1980s. Various macro factors are to blame. Supply shortages, higher commodity prices, and tightened financing followed unprecedented geopolitical uncertainty and the protracted global pandemic, leading to short-term interest rate hikes and slower economic growth.

In such an inflationary market environment, investors looking to preserve their wealth and the long-term performance of their portfolio should consider diversifying^[1] into real estate. Commercial real estate (CRE) is widely considered to be one of the best inflation-resilient options. CRE may provide a source of stable income, and it may also allow owners to recoup some of their higher costs through rent increases.

Historically, commercial real estate has demonstrated strong performance throughout different economic cycles. In the last 25 years (1978-2022), U.S. commercial real estate outperformed inflation over 87% of the time.^[2] This time period includes high inflation in the late 1970s and early 1980s.

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In this article, we will explain the relationship between inflation, interest rates, and commercial real estate and provide some examples of the best property investments during high inflation.

Inflation and Purchasing Power

Inflation has a significant effect on an individual’s purchasing power. Purchasing power refers to the value of goods or services that can be bought with a single unit of any currency (such as $1). An increase in the price of goods and services typically decreases your purchasing power. When costs increase, you simply won’t be able to purchase as much as you could for the same price.

For example, a pound of coffee cost $6.4 on average in December 2022, while it was priced at $4.43 in 2020.^[3] Supply shortages of coffee beans and trade disruptions have driven the price significantly. Effectively, $5 could get you a pound of coffee two years ago, but now you’ll need another dollar to buy the same product. In other words, your purchasing power is lower today, than it was in 2020.

This erosion of purchasing power in inflationary times certainly impacts the housing market. If the central bank raises interest rates to rein in high inflation (as the Federal Reserve has done) the cost of borrowing (debt, mortgages) goes up. When mortgage rates increase, it is harder for buyers to purchase property within their budgets.

In 2021, for instance, a homebuyer in the U.S. with a $2,500 monthly budget for their mortgage could afford to invest in a home worth up to $517,500, according to a recent study^[4]. In 2022, however, the rise in interest rates means the homebuyer could only purchase a property that costs $399,750. The homebuyer lost $120,000 of purchasing power as a result of rising mortgage rates.

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With fewer people willing and/or able to purchase property, the demand for rental housing has increased. Currently, mortgage payments in the U.S are said to be higher than the average rent in 45 of the 50 largest metro areas, making home ownership more expensive than leasing a property. A long-term investor in commercial real estate can capitalize on this uptick in demand and high occupancy levels by raising rents.

High inflation and interest rates also impact the supply side of the equation. The higher price of raw materials, labor and machinery coupled with greater borrowing costs make it costlier for developers to construct new properties. This is likely to reduce the overall housing inventory. Existing properties therefore appreciate in value, particularly in high-demand sectors like multifamily.

Real Estate as an Inflation Hedge

Commercial real estate has historically increased or maintained its value and overall performance during inflationary periods, and is considered a stable long-term investment. Investors can increase rental rates for fully-built properties to compensate for higher operating expenses or greater demand, so CRE is typically considered an attractive hedge against inflation.

The ability of a particular asset to hedge inflation can vary depending on the type of debt, lease duration, drivers of supply/demand, and cap rate movement. Investors may want to consider these factors before choosing their CRE investment.

1. Type of underlying debt: Investors typically use a combination of equity and debt (such as loans provided in the form of a mortgage) to finance a real estate investment. Different types of mortgages have different levels of sensitivity to interest rates. A mortgage financed with fixed-rate interest throughout the period of the loan will be more stable in the face of fluctuating interest rates than properties with floating-rate (also called variable interest rate) debt. These types of mortgages adjust according to market conditions or a specific reference rate).
2. Lease duration: Shorter leases allow investors to promptly revise rents or alter lease agreements to account for rising inflation. The length of a lease is specific to the property type. Hotels, for example, can reprice room rates daily. Co-working office spaces and alternative sectors such as self-storage often have month-to-month leases. The multifamily sector typically offers short-term leases, with the most common lasting 12 months. On the other hand, conventional office, industrial and retail leases are comparatively longer (10-20 years, in some cases) and it can be hard for landlords to quickly renegotiate lease terms during periods of unexpected inflation. Such longer leases typically contain what are known as escalation clauses. These increase rent annually by a modest percentage, which may or may not be enough to keep pace with higher rates of inflation.
3. Structural supply/demand drivers: Property types that benefit from long-term trends will likely continue to see robust demand and positive rent growth irrespective of the macro environment. Take the multifamily sector, which benefited from the cultural shifts in how we live and work that accelerated in the early years of the pandemic. The industrial sector, too, saw accelerated demand due to rapid digitization and widespread adoption of e-commerce. Regional malls and suburban office buildings, however, face continuing headwinds. The trend toward hybrid working and reduced consumer spending has reduced occupier demand, produced higher vacancies, and lowered revenues. This is exacerbated during inflationary periods.
4. Cap rate movement: Capitalization (cap) rate is the ratio between a property’s net operating income (NOI, the asset’s expected annual income minus management expenses) and its current market value. Cap rate is used to estimate a property’s potential cash yield before factoring in mortgage financing.

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In general, when cap rates expand, the property’s expected risk and return levels also increase. This happens because the value of the property is derived either from higher projected future cash flows or lower current valuation. When cap rates compress, it means the property’s current equity valuation has increased. Generally speaking, property owners benefit from lower cap rates as it may mean that the value of their property has gone up.

Cap rates are influenced by a range of factors including interest rates, inflation, rent growth, Gross Domestic Product (GDP), and employment, as well as the property’s location and sector. These factors can all counterbalance inflation’s impact on cap rates. Higher interest rates would theoretically cause a cap rate expansion, but could be offset by a greater NOI, or a sector subject to growth tailwinds.

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Housing shortages and rising rents have helped multifamily cap rates compress from 5.2% during the peak of the pandemic in Q2 2020 to around 4.5% in Q1 2022, despite mortgage rate increases^[5]. Similarly, high demand for industrial space and low vacancy rates have lowered cap rates in the sector to 3.5% versus 6% in Q2 2020. Since cap rate is often a side effect of rising property prices, multifamily and industrial sectors have recorded the strongest price gains amongst their peers, at 22% and 30% respectively, as of the first quarter of 2022.

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Your risk appetite as an investor should determine your cap rate expectations and investment selection, particularly during periods of high inflation. While almost all privately held commercial real estate may provide better inflation protection than stocks and bonds, some properties fare better than others. Historically, privately-owned multifamily apartment buildings have outperformed their peers when inflation exceeded 5%. Multifamily assets generated 12.71% returns during such periods. Second best are industrial assets, which achieved 11.72% returns.^[6]

As a long-term real estate investor, a macro environment with high inflation and rising interest rates can be a net positive. The results will depend in part on the holding period of your investment, the property type, the type of financing, and the underlying lease structure of the asset. Inflation can put upward pressure on both cap rates and real estate prices, but the right investment may allow you to maximize net operating income, maintain or increase the property’s overall value, and generate the best risk-adjusted returns for your portfolio.

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