Inflation & Commercial Real Estate
Unless you have been doing a digital detox, you have been inundated with news about inflation’s impact on mortgage rates and the financial markets. To control inflation, the Federal Reserve has raised the Federal Funds Rate four times this year and is poised to increase it another 50-75 basis points (0.75%) in November.
The news has commercial real estate investors asking how prolonged inflation will impact their assets and investing strategies. We will dive into those questions below.
The book definition of inflation is a change in the overall price of goods and services over time. The most reported measure of inflation is the Consumer Price Index (CPI), which is produced by the Bureau of Labor Statistics (BLS) and is a measure of price changes for a basket of 80,000 common consumer goods and services.
While CPI grabs the headlines, the Fed measures inflation using the Personal Consumption Expenditure (PCE) price index, which is a product of the Bureau of Economic Analysis (BEA).
The last time PCE was near the Federal Reserve’s 2% target was early 2021. Since then, PCE and CPI peaked in June this year at 6.8% and 9.1%, respectively. Whereas CPI focuses on consumer out-of-pocket costs, PCE measures inflation across a larger segment of the economy.
Inflation and the actions of central banks worldwide have impacted both large and small markets.
The Dow Jones Industrial Average is down almost 15% year-over-year (YoY), and the S&P 500 Index is off approximately 17.5%. Traditionally seen as a recession indicator, Treasury yields have inverted, with 2- and 5-year yields clocking in at 4.31% and 4.17%, respectively, while 10- and 30-year yields are coming in under 4.00%. Even the ultra-hot Crypto market has been thrown into a deep winter after losing $2 trillion of its $3 trillion market cap in early 2022.
The real estate market has not escaped the impacts of inflation and rising rates. After hitting historic lows in 2021, residential mortgage rates climbed from 3.10% in January 2022 to 6.70% by September. Commercial lending has also seen a dramatic rise in lending rates, with current bank rates floating between 5.50% and 6.50%. Together persistent inflation, rising interest rates, and historic appreciation have begun cooling what has been a super-hot market.
The Real Estate Advantage
Commercial multifamily often fares better than most other asset classes during inflationary periods. However, even in down markets, there are opportunities for real estate investors. For starters, real estate is considered a hedge against inflation because:
- rental prices tend to track CPI.
- the ability to pass cost increases to tenants.
- the ability to capitalize on rising value.
Let’s dive deeper into these advantages.
Rental Prices and CPI
Housing costs are included in the “basket” of goods used to calculate the Consumer Price Index, particularly rental costs. If a surveyed individual is a homeowner, their housing costs are calculated as a rental equivalent, not their actual mortgage costs. So, you can say rental prices are baked into the CPI.
Historically, rental rates have kept up with inflation – even during the 1970s and 1980s, when inflation hit double digits. For example, in 1980, the Year-over-Year rental growth rate was just under 12%, and there has not been an appreciable negative growth rate since the 1930s. Does this mean that we will not see negative rental growth rates in the future – no, but the likelihood of sustained negative growth rates is very low.
Passing Costs to Tenants
Another way real estate is a hedge against inflation is the ability to pass increasing costs on to tenants. Depending on the asset class, this is accomplished in several different ways.
In commercial real estate (CRE), the triple net lease (NNN) is the gold standard. When properly structured with programmed rent increases, rental reviews, or rates tied to a benchmark, owners can effectively pass inflationary costs to tenants.
In the multifamily space, short-term leases allow owners to regularly reset rents to market rates. For example, when a one- or two-year lease expires, the owner can increase the rent to the market rate. These increases are magnified if the current tenant remains in place – higher rents are collected without turnover costs.
Since rental rates track CPI, and properties are valued off Net Operating Income (NOI), owners can see a rise in property value during inflationary periods. Capturing potential value from increasing rents requires owners to keep operating costs as low as possible without negatively impacting the tenant experience.
Depending on how their debt is structured, owners can also benefit from an improved Loan-to-Value (LTV) ratio and Debt Service Coverage Ratio (DSCR). As NOI increases, the balance between debt costs to cash flow will likely improve. Improving DSCR is more likely to occur when debt payments are fixed. Since commercial loans are often constrained by DSCR or an owner’s net worth, improving these ratios can be very beneficial.
Even during inflationary periods, owners can pull equity from a property by refinancing – assuming they can secure favorable terms on the debt. Investors can then reinvest their funds into the original property or use them for other investments.
Of course, an owner with an in-demand property can always sell the asset to capture equity. After the sale, the owner can take advantage of a 1031 exchange and invest the proceeds into a like-kind property.
So, what do investors need to do to position themselves and their assets during inflationary periods?
First, they need to educate themselves on the effects of inflation on their preferred asset classes and markets. For example, properties at the top and bottom of the spectrum do not historically perform as well as mid-class properties during recessions.
Second, property owners must evaluate their assets and ensure they are efficiently managed. While it is possible for an investor to self-manage their properties, it is advisable to consider the benefits of hiring a professional management company. In many cases, these companies are better suited to maximize asset profitability and will bring greater value than the fees they charge.
Third, investors must also evaluate their portfolios and investment strategies to ensure they are positioned to capitalize on shifting markets. This ties back into self-education and asset management. Investors can adjust their investment strategy to match current conditions when they understand the changing markets.
How We Can Help
There are opportunities in all markets – and in many cases, there are more opportunities in down markets. The real estate market has been trending since the housing market collapse and the ensuing Great Recession. Now the markets are shifting, and investors will have new opportunities.
Sweetwater Capital has experts in Commercial Mortgage Brokerage, Investment Sales, and Commercial Property Management. Let us help you capitalize on current opportunities and position your assets to take advantage of the shifting markets.