New Fundamentals: Inflation

Inflation in the U.S. recently reached rates we haven’t seen in four decades. Gas prices passed previous record highs for all time, climbing above $5 nationally. Interest rate hikes from the Federal Reserve meant to bring those costs back down spurred mortgage rates up to levels we haven’t hit for more than a dozen years. Supply and labor shortages continue to make headlines, causing difficulties from coast to coast. Money just isn’t worth what it was even a year ago.

Investors who want to protect their purchasing power in the current environment should consider allocating to real assets. Cash and bonds generally lose value throughout inflationary periods. Equity returns can be mixed and will likely be incredibly volatile. But real assets such as real estate have been shown to hedge quite effectively against rising rates.[1]

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The Effects of Inflation on Long-Term Assets

The effects of rising inflation affect asset classes in many different ways. Both cash and fixed income instruments are typically negatively affected by inflation. Prolonged increases in the price of goods and services ultimately erode the value of consumers’ purchasing power. Equities can also be volatile throughout inflationary periods, as the rising cost of materials and wages may shrink profit margins. Ultimately, some companies may be able to pass a portion of those cost increases through to consumers. But that takes time, and is not guaranteed to be successful, leaving the value of stocks in flux.

Real assets—and real estate in particular—tend to maintain their value or potentially see their value increase in inflationary environments. Commercial real estate owners have the ability to seek increased rents on shorter-duration contracts, such as residential leases that are typically one or two years in duration. Longer-term leases typically have escalation clauses that increase lease rates over time, which may help preserve owners’ purchasing power against inflationary trends. Real estate owners may also be able to directly pass expenses through to their tenants, potentially limiting the negative impact of rising costs. While there are risks to investing in CRE in inflationary periods, such as higher interest on floating rate loans and potential tenant vacancy, there are many potential upsides. Investors may consider adding commercial real estate to their portfolio, or increasing their allocation to it as a hedge against rising interest rates.

The Importance of Inflation Protection

An important consideration: the value of money is not intrinsic. Money’s value is based on the amount of goods and services it allows you to purchase. If you do nothing with your money, it will steadily lose value. With inflationary price increases over 8.6%, $1,000 today may only purchase what you were able to buy for ~$914 the year before. As prices rise over time, the amount of goods and services you’re able to purchase with that money is decreasing.

Higher-than-expected inflation can also have negative consequences for financial assets, with both bonds and stocks adversely impacted. An historical study by Fama and Schwert ^[2] demonstrated that a 1% increase in the rate of inflation caused bond prices to drop by 1.54% and stock prices by 4.23%. In contrast, inflation may have a positive impact on real assets. The only asset class Fama and Schwert tracked in their study that was positively affected by inflation was real estate.

Historically, equity and bond markets tend to be ineffective hedges against rising inflation—for very different reasons. As inflation rises, unless companies are able to pass their cost increases through to consumers, they will see their profit margins shrink. This can cause the value of their stock to go down. The risk to bonds, however, in a rising inflation environment is driven more by the specter of rising interest rates. As inflation picks up steam and gets ahead of Fed target rates, the market expects the Fed to increase those rates in order to slow down the economy. As rates move up, the price of bonds issued in lower-rate environments come down. Bonds that pay a fixed coupon also expose investors to the negative impact of inflation through the diminished value of fixed payments. Bond prices, therefore, are inversely correlated to interest rates.

Commercial real estate, however, has over the last several decades proven to be an attractive hedge against inflation. It holds intrinsic value, is available in limited supply, offers owners the ability to increase rents in response to rising inflation, and may also be shielded from inflation-driven cost increases. Additionally, higher inflation typically occurs during times of economic growth. During such periods, property owners are generally able to find tenants more easily and may be able to increase rents commensurate with the rate of inflation.

Take, for instance, a triple-net lease, which holds the tenant responsible for 100% of property-related expenses. As utility and maintenance expenses rise with inflation, the landlord may remain (at least partially) insulated from their effects on the property’s cash flow. Triple-net commercial leases pass more of the ongoing expenses for the property to the tenant. Such expenses may include real estate taxes, building insurance, and maintenance in addition to rent and utilities.

Of course, CRE investing is not risk-free. In times of inflation, tenants may have a more difficult time making payments. Retail tenants could go out of business, increasing vacancy rates. Throughout an inflationary environment, it may also be difficult to find new tenants. So due diligence prior to investing is of utmost importance.

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Reasons why commercial real estate may make sense as a hedge against rising inflation:

Increasing Cash Flows

Commercial real estate leases often provide opportunities for property owners to increase rents over time. Shorter-term leases adjust at the end of the lease, while longer-term leases generally contain contractual rent escalations. As these terms are fixed, rate adjustments may lag behind sudden changes in inflation, but the ability to increase income over time is usually built into the contract.

Shorter-term leases allow owners to adjust to rising inflation more quickly. Hotels can change their prices daily; multifamily leases tend to range from monthly to annual contracts, and office buildings tend to have longer-term leases of 5-10 years or more. Additionally, property owners have an opportunity to reprice rents as prices increase when these leases reset.

For retail properties like malls, rents may be tied, in part, to nominal sales figures, effectively moving with the broader economy. Such leases are tied into revenues. As stores charge their customers more, the mall owners charge them more for rent. Thus, in an equilibrium situation, rents would go up along with the inflation rate, so income from those properties would be expected to rise at a similar rate.

In recent times, actual pre-tax cash flows from commercial real estate (Net Operating Income Growth) have kept pace with—or outpaced—inflation for the last 30 years ending March 31, 2022.

Expense Reimbursement

Real estate investments may also be able to keep pace with inflation through expense reimbursements. Many commercial real estate leases are able to pass at least some degree of the property’s operating expense burden onto its tenants.

Cost of Capital

Commercial real estate is frequently financed using fixed rate loans with terms as long as 10 years. Property owners often borrow anywhere from 60 to 70% of the property value, so loans are a big part of the capital stack. If inflation occurs during a loan period with fixed monthly interest payments, a property owner would not be exposed to a sudden rise in interest rates. However, any financing that is done with floating rate loans may be at risk of higher interest rates in a period of rising inflation. Additionally, it may prove to be difficult to secure a mortgage during times of high inflation, including to refinance an existing low fixed rate mortgage. Fewer loans are made available, and banks that provide them often charge higher interest rates.

Conclusion

Investing in commercial real estate may benefit an investor’s long-term portfolio allocation, particularly in periods of dislocation, such as an inflationary environment. Commercial real estate is a hard asset which can produce current cash flow. It has the ability to increase cash flows based on market conditions throughout a cycle, allows for expense reimbursement, and allows owners to deduct depreciation losses on their taxes. Overall, it may be both an attractive long-term investment and an effective hedge against rising inflation.