Inflationary Effects On Commercial Real Estate
Anyone investing in the current economic environment needs to consider inflation’s impact on their investment model or forecast.
For the past 40 years, inflationary pressures have been present every year, albeit mild. From 1991 to 2020, average annual inflation ranged from 0.7% to 4.1%. Inflation became more pronounced in 2021 and 2022, hitting 7% and 6.5%, respectively.
Inflation can have multiple impacts on investors. Aside from reducing purchasing power, asset devaluation can further reduce an investor’s returns.
When necessities cost more, investors have less discretionary money to invest, and their existing assets, such as retirement accounts, can become less valuable. When raw materials cost more, many companies are unable to pass along those increases in full to their customers, and that can reduce margins.
Given these varying dynamic forces, investors look for safer investments given today’s economic climate. Should they consider commercial real estate, even after inflation has already increased?
Warren Buffett’s Advice About Combating Inflation
At his 2015 annual Berkshire Hathaway shareholder meeting, Warren Buffet was asked what types of investments are best to thrive during high inflationary periods. Buffett's response, “The best business to own is one that doesn’t require continuous reinvestment because it becomes more and more expensive as the value of the dollar drops.”
He added, “the best business during inflation are [ones] that you buy once, and then you don’t have to keep making capital investments subsequently.” Buffett further said, “[It's] particularly handy to own real estate during times of inflation because the purchase is a one-time outlay for the investor, and has the added benefit of being able to be resold.”
How Commercial Leases Hedge Against Inflation Risks
Real estate can provide numerous benefits to investors in times of high inflation. For example, long-term commercial leases generally are structured to include pre-negotiated annual rent increases. Even if current economic conditions lead to landlords reducing rents to attract new tenants, previously negotiated and committed commercial rents are a tenant’s contractual obligation. Annual rent increases are typically tied to a CPI index or based on fixed steps.
Residential leases are often short-term, which means they can increase or decrease annually with market conditions. Alternatively, commercial leases offer both long-term security (such as a 10-year lease term) and protection from inflationary pressures through contract-required annual rental rate increases.
Some commercial leases also shift operating expense increases off the landlord and directly onto the tenant. For example, NNN leases generally permit a landlord to pass 100% of their operating expenses, and any future cost increases, onto the tenant. With this lease structure, all the inflation risk is shifted from the landlord to the tenant.
Another type of commercial lease utilizes a “Base Year” stop. With this structure, a landlord pays a fixed amount for operating expenses (typically the total amount in the tenant’s initial lease year), but thereafter the tenant pays all amounts over that “Base” in future lease years. This effectively shifts that inflationary risk off of the landlord.
Since the Fed started increasing its Funds rate to combat inflation, interest rates on residential mortgages and commercial real estate loans escalated, impacting an investor’s cost of funds. Borrowers who had floating-rate loans immediately experienced an increase in their monthly interest expenses. Savvy commercial real estate investors locked in historically low sub 4% interest rate loans, prior to the Fed’s actions. Not only did this eliminate interest rate risks from the equation, but it potentially benefits the investor by bridging the current higher market conditions until a future period when hopefully lower rates return.
Is This Still A Good Time To Invest In Commercial Real Estate?
Volatile market conditions really demonstrate the benefits of investing with a knowledgeable real estate partner or Sponsor. Recognizing opportunities to shift inflation-hedging obligations from a landlord to a tenant, as described above, and applying appropriate acquisition underwriting criteria help protect investors.
With many institutional commercial real estate investors waiting for economic conditions to improve, savvy local sponsors/operators can benefit from the current environment. Opportunities can arise when uncertainty is present because there is less capital and less competition currently pursuing new investments.
Being a market fundamentalist and applying sound, long-term assumptions to financial projections, an investor can minimize their risks and help ensure more stable returns. Various conditions lead to owners selling real estate at less-than-ideal times. Death, tax obligations, and investment funds reaching their required end date, all led to opportunities for potential buyers.
High inflationary periods also challenge a real estate operator’s skills. Managing a property’s operating expenses becomes more difficult as the cost of supplies, contracted labor, and utilities escalate rapidly. In times like this, smart commercial real estate sponsors/operators will focus on improving energy efficiency.
Many utility companies offer rebates to help their commercial customers reduce initial costs and shorten payback periods. As utility rates increase, payback periods for certain energy-efficient projects look more attractive.
Bulk supply purchases, especially for items needed over the 12 -24 months, can also assist in reducing overall costs. Items such as air filters, refrigerants, and compressors can be purchased and placed in inventory, without becoming obsolete over the next 12-24 months. Being a creative sponsor/operator can minimize the inflationary impacts and help protect a property’s bottom line.
Diversification and Capital Preservation
Uncertain economic times can highlight the value of investment diversification in every investor’s portfolio. Stocks and bonds provide opportunities to invest in publicly traded companies, which provide liquidity, compared to most real estate investments. However, stock prices can be more impacted by short-term economic conditions and increase their volatility.
Real estate assets are an ideal method for investors to diversify their investments. Commercial real estate investments can provide steady cash flow from long-term leases and offer the ability to secure long-term fixed-rate debt, which can produce superior returns during volatile times.
Stocks can experience significant volatility based on statements from the Fed Chairman, pressure from Wall Street analysts, or a company’s efforts to meet quarterly earnings expectations. Real estate investments are generally much less impacted by these short-term events and help provide the capital preservation that investors desire.
Invest in Commercial Real Estate with Kenwood Management
At Kenwood Management, our Sponsors invest their money along with outside investors in every acquisition. Our long-term strategy focuses on generating steady cash with an emphasis on renewing tenants, over and over again. Kenwood Management is always looking for new investors to join the Kenwood Community. Learn more about our investment services and how we focus on generating steady returns and capital preservation through commercial real estate investments.