Worried About Inflation? Look to Commercial Real Estate as a Potential Hedge.
From the gas pump to the grocery store, consumers have been feeling the pinch of rising prices as the country recovers from the pandemic and the supply/demand equation tries to right itself.
But when lumber prices quadrupled in the 14 months following the COVID-19 outbreak in March 2020,1 warning sirens sounded for a potentially long and painful inflationary period, which grabbed the immediate attention of investors.
In a recent article published by the research firm Blue Vault, the author builds a compelling case for why investors should consider commercial real estate (CRE) as a potential hedge against inflation. We will discuss this in more detail, but first, a few basics.
What’s Behind The Current Price Spikes?
Many factors can contribute to a rising price environment. The most cited reason is the disconnect that occurs when demand for products and services is greater than the supply of those products and services. With our economy reopening and consumer spending on the rise, suppliers who were forced to throttle back at the height of the pandemic are struggling to meet current surges in demand. That boosts prices and reduces the spending power of the dollar. And voila, inflation.
The challenge for investors concerned about rising inflation is not knowing how bad it will be or how long it may last. When facing the unknown, if you follow the adage, “hope for the best, prepare for the worst,” it may be prudent to look at investments that have performed well during inflationary periods. CRE is one of those investments, and as mentioned in the Blue Vault article, here are a few key reasons:
Limited CRE inventory can lift property valuations and rental income
As production costs rise due to higher wages and increasing material costs, new real estate construction projects become very expensive and may be delayed or canceled. This limits CRE supply, which can elevate property values and allow owners to raise rental rates.
While inflation can have a detrimental effect on publicly traded stocks and bonds, which are subject to market movements and macroeconomic factors, rising inflation can enhance the performance of certain CRE investments less correlated with the markets.
CRE leases generally have built-in rent escalations
Many CRE leases include rent escalation clauses, often tied to the Consumer Price Index (CPI), which enables property owners to increase rents at the same rate of inflation. That provides investors a powerful built-in inflation hedge.
In addition, the pervasive low-interest-rate environment we have been experiencing allows property owners to borrow and lock in long-term debt at low fixed rates. The combination of increasing cash flows and the low cost of capital can have a meaningful impact on enhancing investment returns.
Of course, there are risks to consider with any investment, and CRE has its own set, which any interested investor should become familiar with. When it comes to protecting investment portfolios from the corrosive effects of inflation, CRE is a unique solution that is worth a closer look.
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The views expressed herein are subject to change based upon economic, real estate and other market conditions. These views should not be relied upon for investment advice. Any forward-looking statements are based on information currently available to us and are subject to a number of known and unknown risks, uncertainties and factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements.
Important Risk Factors to Consider
Investments in real estate assets are subject to varying degrees of risk and are relatively illiquid. Several factors may adversely affect the financial condition, operating results and value of real estate assets. These factors include, but are not limited to:
- changes in national, regional and local economic conditions, such as inflation and interest rate fluctuations;
- local property supply and demand conditions;
- ability to collect rent from tenants;
- vacancies or ability to lease on favorable terms;
- increases in operating costs, including insurance premiums, utilities and real estate taxes;
- federal, state or local laws and regulations;
- changing market demographics;
- changes in availability and costs of financing;
- acts of nature, such as hurricanes, earthquakes, tornadoes or floods;
- economic risks associated with a fluctuating U.S. and world economy, including those resulting from the novel coronavirus and resulting pandemic.