Inflation is defined as the general rise in the price of goods and services over time, resulting in the sustained drop in the purchasing power of money.
In an inflationary environment, ownership of “hard” or “tangible” assets can be an effective way to hedge against rising prices. Commercial real estate is one such asset. While inflation can seem scary, many experts and economists actually consider a small amount of it to be a sign of a healthy economy. This is because it encourages consumers to spend money today rather than save it and watch its purchasing power erode over time.
Returns from a commercial real estate investment come from two places—income and capital appreciation—which work in tandem to hedge against high inflation.
To understand why commercial real estate is such a resilient asset, it is imperative to know the grounding basics of this investment. Any commercial property, be it as small as a two-floor shopping center, or as large as an industrial warehouse, has its lease terms as its main saving grace. While allowing tenants to rest assured of a long-term commitment to conduct their operations, the lease agreement also allows investors to also be convinced that a long-term investment in this is not going to go awry.
Even during the uncertain times of the pandemic scenario of 2020, the commercial real estate market was among the few investments that remained rather insulated from the volatility of the market and started on a recovery path much sooner. These quick recovery times for this asset class are the major reason why investors make a beeline for CRE assets.
High inflation should be on the watchlist of any prudent investor because it can seriously undervalue any investment, as well as cause a dent in future cash flow. That is why investments should be such that they achieve higher returns than the going or expected rate of inflation. Let us try and understand that through an example.
From a very simplistic view, let us assume that the current inflation rate is around 5%. This would mean that investments in any asset that offer returns below 5% are actually making a loss in their purchasing power each year, relative to inflation. That would include even the safest and most basic of investments – fixed deposits. Even other safe investments like money markets and debt can also suffer from this loss. The only hope is that in the long term, the inflation rate might stabilize and the investments will start providing positive returns.
Despite that, in the long run, if the investment is left as is, the capital of the investor is able to purchase less because the cost of goods and services has increased at a faster rate than the returns provided by their investments.
To ensure such a scenario does not happen, assets need to have a higher rate of return than the current or future inflation rates, at least to the point where the returns generated are not negative. Inflation rates will mostly keep going up – the reasons for that are various and complex.
There are three major ways in which CRE can protect investors from inflation.
Rising inflation contributes to rising prices. That is a given fact. Rising prices also include rising rents for commercial properties. Property rental rates increasing while operating expenses stay relatively stable contribute towards positive property values.
Now, this can cause an increase in net operating income, which will appreciate property values further. As long as this value is more than the inflation rate, the investor’s investment will not be hampered if they are holding CRE.
Lease agreements for commercial properties are structured in a way that increases the rents at regular intervals throughout the lease term. An agreement, for example, could have a clause that calls for an increase in the rent at the rate of 2% to 3% annually.
Based on the property and the demand and supply of the market, the clause for different assets will be different. As long as these regular increases outpace the inflation rate, the relative return will stay positive.
It is a no-brainer that space will always keep decreasing. As more houses, apartments, buildings are created to increase the supply of real estate, it conversely also creates scarcity of space. Companies will keep growing and more companies will keep opening, the requirement for commercial real estate will keep on increasing.
In dense real estate markets and commercial centers, high demand and limited supply contribute to the appreciation of prices for real estate, which is positive for investors. So, if the price increases are more than the inflation rate, the relative return stays mostly positive.
For those interested in Investing in Commercial real Estate to hedge against inflation, there are three potential ways to invest in it. We wrote a separate Article on that.