Commercial Real Estate: The Impact of Inflation

by | Feb 21, 2023 | Investing Advice

In simple terms, inflation refers to a rise in prices and a decrease in the value of money, resulting in increased costs for goods and services while income remains constant. Currently, the United States is facing an all-time high inflation rate, the highest in three decades. Despite this, there is some positive news in that real estate is considered a hedge against inflation. In fact, commercial real estate has been drawing more investors due to the positive impact of inflation on this asset class, even though it may seem counterintuitive at first.

How Does Inflation Affect Commercial Real Estate?
Commercial real estate offers multiple advantages to investors during times of inflation. Keep reading to discover the key ways inflation affects real estate, particularly how a multifamily inflation hedge is created.

#1 – Housing Prices
Along with everything else, housing prices rise with inflation. For owners, this means their assets will appreciate more quickly. In the current financial climate, property owners are seeing record highs in appreciation. Prices will eventually even out, but even then owners can expect 6-9% increases to remain in many markets.

#2 – Mortgage Payments
Fixed-rate mortgage payments don’t change, but over time the equity in the property grows. During inflationary periods, as housing prices soar, the asset appreciates at an increased rate, yet the monthly payment never changes. Rents on single family homes have been on a steady upward swing over the last year. CoreLogic reported that September 2021 data showed a national rent increase of 10.2 percent year over year, and inflationary pressures will hit the rental market as well.

How Is Real Estate A Hedge Against Inflation?

Initially, the relationship between inflation and real estate investments may appear unfavorable. However, investing in rental properties can serve as a built-in defense against inflation, resulting in a positive outcome. Typically, investors are not only shielded from inflation, but they can actually gain advantages from it.

Rental Income Increases
With most investments, like stocks, for instance, the value dwindles during an inflationary period. With real estate investments however, home values and rental prices increase during inflationary times. Having a place to live is a necessity, not a luxury. So, even when prices are at an all time high, people aren’t able to avoid the expense of viable housing. According to Forbes, the winning formula to profit as a real estate investor during an inflationary period is to tie a cash-flowing property to a long-term fixed interest rate debt. With a fixed rate mortgage on your rental properties, inflation raises the rent payments but the interest payments stay locked at the same low rates, resulting in an increase in cash flow from the property because of inflation.

In commercial real estate leases, rent increases are a common expectation, with regular or annual increments outlined in the agreement. This rent increase results in a higher property value, and if the increase rate surpasses inflation, investors can experience positive returns. During inflationary periods, real estate investors often enjoy accelerated returns due to rising home values and increasing asset equity. For example, if an investor put down 10% on an asset and inflation increases by 10%, their down payment doubles, along with their equity in the property. Despite the reduction in the value of dollars by 10%, the increase in equity benefits the investor, as the tenants’ income and the fixed-interest on the bank’s loan is leveraged. Ultimately, investors will emerge ahead with a higher return on equity, despite inflation.

Property Scarcity
The price of commercial real estate property is partially driven by scarcity. This is especially true in metropolitan areas where population growth has created a limited supply of space. When demand is high and inventory is low, real estate investors are positively affected, as long as price increases outpace the rate of inflation. Property scarcity is at an all time high in the U.S. currently, and real estate investors are benefiting greatly from the rise in prices, as well as the increased need for adequate housing.

How Real Estate Compares To Other Investments

Real estate investing typically holds less risk than other investments, particularly the stock market, while continuing to deliver good returns and the opportunity to build wealth. For a broadly diversified portfolio, holding commercial real estate is highly recommended. The higher returns gained from real estate investments can offset volatility and/or the lower returns for bonds and mutual funds during inflationary periods.

Building Wealth In A Poor Financial Climate
The sustainability of real estate investing is, particularly during periods of inflation, is one of the top reasons investors are flocking to real estate. According to Forbes, “real estate has made more ordinary people wealthy than any other investment vehicle.” During inflationary periods, the value of your debt diminishes right along with your equity. Many people are turning their equity into debt by implementing cash-out refinances. While the general population is searching for some type of hedge of protection against the inflation we’re experiencing in this country, real estate investors are thriving. Investors who understand the advantage of relying on real estate are currently building their wealth at an increased speed. Investing in real estate allows you to use debt to your advantage and continue to build wealth even in a poor financial climate.