Three Ways That Commercial Real Estate Protects Against Inflation

Anthony Grosso is Co-Founder, Co-Chairman, and Managing Principal of First National Realty Partners.

In early 2021, the business news was full of inflation-related headlines. Lumber prices were soaring, adding up to $36,000 to the cost of a new home. Used car prices were touching record highs, gasoline prices were on the move, and food prices were surging.

The reasons for rising prices are various and complex, but there is no doubt that key goods and services are getting more expensive. There is some question about whether this is a short-term inflationary blip or the beginning of a more extended rise in prices. Regardless of the answer, this inflationary uptick serves as a reminder that the U.S. has benefited from an extended period of low inflation that will eventually come to an end. When it does — whether now or further into the future — investors should prepare to adjust their investment strategy to hedge against inflation.

In this article, we are going to define what inflation is, why it can be a headwind for investors and how commercial real estate (CRE) assets can serve as a hedge against the loss of purchasing power that results from it.

Why Inflation Is A Headwind For Investors

Inflation is the gradual rise in the price of goods and services over time. It is measured by monitoring changes in the "Consumer Price Index," which is a basket of commonly purchased goods. The United States Federal Reserve is responsible for setting monetary policy, and inflation is one of its primary concerns. It tries to manage inflation to a certain target (usually 2-3% annually) and has the ability to take certain actions when it comes in above or below this range.

High inflation is concerning to investors because it can erode the value of a future stream of cash flow. For this reason, investors need to achieve returns that are higher than the rate of inflation. To understand this point, an example is helpful.

Assume that inflation is running at a rate of 3% annually. If an investor keeps their capital in a money market account that pays a fixed rate of interest at 2% annually, they are actually losing 1% of their purchasing power each year relative to inflation. Over the longer term, their capital is able to purchase less because the cost of goods and services has risen faster than their investment returns.

To avoid a scenario like the above, investors can consider seeking inflation hedges or asset classes that are uniquely positioned to perform well in periods of high inflation. CRE is one of those asset classes.

Commercial Real Estate As A Hedge Against Inflation

There are three reasons why a CRE investment can be uniquely positioned to serve as a hedge against inflation: income, leases and scarcity. Let's tackle each one of these points individually.

1. Rental income rises with inflation. We have already established that rising inflation causes increasing prices. This includes commercial property rental rates. When property rental rates rise, it is a positive for property values as long as operating expenses are held relatively constant. The resulting increases in Net Operating Income drive property values higher. As long as value increases outpace inflation, an investor's purchasing power will not be eroded when holding CRE.

2. Commercial real estate leases call for regular increases in rent. To hedge against inflationary pressure, it is common for CRE leases to contain a clause that calls for rent increases at regular intervals throughout the lease term. For example, a lease could call for rents to increase at a rate of 2% annually. The impact of these increases causes rising income, which leads to rising values. As long as the rate of an increase outpaces inflation, the relative return is positive.

3. Property scarcity often causes price increases to outpace inflation. The pricing of CRE assets is driven, at least in part, by their scarcity. This is particularly true in dense real estate markets where there is a limited supply of space. High demand and limited supply is the right recipe for rising price levels, which is a positive for real estate investors. As long as price increases outpace the rate of inflation, returns will be positive on a relative basis.

These reasons highlight the importance of holding CRE as part of a broadly diversified investment portfolio of risk assets. Higher real estate returns can offset volatility and/or lower returns for equities and bonds during periods of higher inflation.

How To Invest In Commercial Real Estate

For those who have decided to add CRE as part of an inflation protection strategy, there are three ways to make an investment:

1. Buy CRE directly: Investors who have the resources, experience and time to purchase and manage a property can do so directly by working with a knowledgeable broker. This strategy provides investors with a great deal of control.

2. Buy REITs: Real Estate Investment Trusts are companies that purchase, manage or finance real estate. They can be publicly or privately traded and provide investors with a high degree of diversification and all of the benefits of real estate ownership without the hassle of actually managing it.

3. Invest with a private equity firm: Private equity firms invest in the equity of other companies. Through leading my own private equity firm and observing others in the space, I’ve seen that many firms make investments in companies that own real estate. Private equity investments are only available to accredited investors but provide individuals with an opportunity for fractional ownership of institutional quality assets and all of the benefits that come with it.

The bottom line is this: When investing into an inflationary environment, there is a strong argument to be made for CRE assets as part of a broad inflation hedging strategy.

The information provided here is not investment or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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