It comes as no surprise that after experiencing 10 years of steady economic growth and historically low interest rates, inflation is beginning to rise in the United States. With the potential for inflation to continue rising, it’s crucial for commercial real estate investors to understand the causes of inflation, how it impacts commercial real estate, and how to mitigate inflation risk.
Causes of Inflation and How It Impacts Real Estate Returns
There are two economic theories on causes of inflation, demand-pull and cost-push. Demand-pull inflation happens when the relative demand for goods and services expands faster than the supply. An example of demand-pull is the modest inflation we’ve seen in the U.S. over the past decade as a result of the Federal Reserve slashing interest rates in 2008. Lower interest rates give consumers and businesses more incentive to borrow, which then results in more money to spend, and an increase in the demand for the goods and services.
Increased demand for goods and services drives prices higher, including those associated with owning and operating commercial real estate. The economic growth that is associated with demand-pull inflation often impacts commercial real estate in a positive way – it causes greater demand for real estate, which drives up property values and allows owners to increase rents, offsetting inflated property ownership costs.
Cost-push inflation happens when there is an increase in the price of inputs required to manufacture goods or provide services. There is always potential for cost-push inflation to occur; however the potential trade war and growing list of newly imposed import tariffs could be a potential catalyst of greater cost-push inflation to occur in the coming years. Cost-push inflation is typically the less desirable form of inflation, as it can be harder to control and lead to slower economic growth.
Commercial real estate developers and investors can be directly exposed to rising construction prices from import tariffs imposed on steel and building materials. For example, a 25% tariff on steel would raise the price of steel used as the structural framework to construct commercial real estate assets. With all else equal, rapidly rising construction costs could result in relatively lower demand for newly constructed real estate and prevent the developer from selling the property at a higher price to offset their inflated construction costs.
On the flip side, investors who already own existing real estate could benefit from inflation’s impact on construction costs. The more it costs to build or replace an existing property, the more the next buyer is willing to pay for that existing property. For example, an investor might be willing to pay $20 million for a 100-unit multi-family property today that cost $10 million to build in 1988. The investor would be willing to buy the property for $10 million more than it cost to build it 30 years ago because they would alternatively have to pay $25 million in construction costs to build a similar property today. In general, this rule holds true up until a point where the price of the property and associated financing costs would no longer allow the investor to achieve positive cash flows or investment returns from the property.
Three Ways to Mitigate Inflation Risk
1. Lease Structure: Inflated operational and maintenance costs can be offset in office and multi-family investments by utilizing gross leases with expense stops, escalating rents, and short-term leases. Gross leases with expense stops require the tenant to pay out of pocket for expenses that exceed a price ceiling set in the base year of the lease. These expenses can include utilities, property taxes, insurance, and maintenance. Escalating rents are future increases in rent set forth at the beginning of a lease. And short-term leases allow the owner to reset rents annually, based on market trends, newly added renovations, or rising inflation.
At Origin, we utilize gross leases with expense stops and escalating rents at our office properties and short-term leases (typically one year) at our multi-family properties. These three lease terms are advantageous to a property owner in times of inflation as they offset inflated operations expenses with parallel increases in rent.
2. Location: The importance of location cannot be understated. An investor that owns properties in a strong and economically resilient market will be more likely to achieve inflation-offsetting returns than an investor that owns properties in a non-diverse market with weak demand. A weak local market with real estate supply that exceeds tenant demand creates a challenging environment for owners to maintain stable occupancy, rent growth, tenant affordability, and thus investment returns.
Strong and economically resilient markets with barriers to entry, a diverse industry presence, and proven growth will help create real estate demand that outstrips supply. This is why we require these key attributes when choosing our investment markets at Origin.
3. Capital Stack Diversification: A real estate capital stack typically consists of debt and equity. Diversifying real estate investments across both parts of the capital stack can help to smooth overall returns during periods of inflation since debt and equity investments tend to perform differently in different economic conditions. In the case of inflationary periods, debt investments with fixed interest payments will underperform, compared to periods of low or falling inflation. For example, an investment in fixed-rate commercial real estate debt might provide annual interest payments of 7%; however, if inflation rises from 2% to 4%, the investor’s real rate of return would drop from 5% to 3%.
Investments on the equity side of the capital stack can act as a hedge against inflation, performing better during these periods under the replacement cost and lease structuring concepts detailed earlier. The combination of both debt and equity investments in a commercial real estate portfolio can help to mitigate the negative impacts of inflation and balance out risk and reward.