How to Make the Most of Your Inflation Hedge
By David Vincent, investment products specialist, Cadre
Inflation is here to stay. November’s 6.8 percent jump in year-over-year consumer prices confirmed fears that rates would remain higher.
Now, as investors seek out opportunities for sustained value and long-term growth under changing conditions, hard assets like real estate may become even more appealing. After all, commercial real estate has proven to be an attractive hedge against inflation over the last 40 years.
Most experienced investors understand that holding on to your money with the old cash-under-the-mattress technique sadly offers no protection in inflationary periods. Prolonged price increases ultimately erode the value of consumers’ purchasing power. The money you’re sleeping on (or, more realistically, keeping in a low-rate bank account) is steadily losing its real value. As prices rise over time, the amount of goods and services you’re able to purchase with that money is decreasing.
Higher-than-expected inflation can also have negative consequences for stocks and bonds.
A historical study by economists Fama and Schwert demonstrated that a 1 percent increase in the rate of inflation typically causes bond prices to drop by approximately 1.5 percent and stock prices by 4.2 percent.
In contrast, inflation may have a positive impact on physical assets. The only asset class Fama and Schwert tracked in their study that was positively affected by inflation was real estate.
Why is this? Assets like commercial real estate hold intrinsic value, are available in limited supply and offer owners the ability to increase rents in response to rising inflation. In many cases, these assets can also be shielded from inflation-driven cost increases.
Additionally, higher inflation typically occurs during times of economic growth. During such periods, property owners are generally able to find tenants more easily and potentially able to increase rents commensurate with the rate of inflation.
Of course, CRE investing is not risk-free. In times of inflation, tenants may have a more difficult time making payments. Retail tenants could go out of business, increasing vacancy rates. Throughout an inflationary environment, it may also be difficult to find new tenants. Due diligence prior to investing is of utmost importance.
For those aiming to navigate the risks and opportunities in commercial real estate, here are a few key tips to keep in mind.
Identify Assets with Cash Flows
Leases that can be adjusted for rising inflation may be particularly valuable. For example, multifamily housing complexes typically offer leases that can keep pace with or outpace inflation.
Shorter-term leases allow owners to adjust to rising inflation more quickly. Hotels can change their prices daily; multifamily leases tend to range from monthly to annual contracts, while office buildings tend to have longer-term leases of 5 to 10 years or more. Additionally, property owners have opportunities to reprice rents when these leases reset.
Find Safe, Fixed Rates
Since commercial real estate is frequently financed using loans with lengthy terms, inflation may occur during a period with fixed monthly interest payments. Properties with floating-rate loans are at higher risk of interest rate changes during inflationary periods.
Commercial properties are frequently financed using fixed-rate loans with terms as long as 10 years. Property owners often borrow anywhere from 60 to 70 percent of the property value, so loans are a big part of the capital stack. If inflation occurs during a loan period with fixed monthly interest payments, property owners would not be exposed to a sudden rise in interest rates.
However, any financing subject to floating-rate loans may be at risk of higher interest rates in a period of rising inflation. Additionally, it may prove to be difficult to secure a mortgage during times of high inflation, or to refinance an existing low-fixed-rate mortgage. Fewer loans may be available in periods of rising inflation, and banks that provide them often charge higher interest rates.
Smart Operators Can be Key
There are a number of methods that commercial owners can take to reimburse their operating costs. Attractive lease structures and tax deductions for property depreciation can reduce the burden of inflation-related costs and help insulate owners from these risks. Operators that understand how and when to use these mechanisms can determine the lasting value of an investment.
Take, for instance, a triple-net lease, which holds the tenant responsible for 100 percent of property-related expenses. As utility and maintenance expenses rise with inflation, the landlord may remain (at least partially) insulated from these effects on their cash flow.
Triple-net commercial leases pass more of the ongoing expenses for the property to the tenant. Such expenses may include real estate taxes, building insurance and maintenance in addition to rent and utilities.
Ultimately, the same fundamental truths about commercial real estate apply, both in and out of times of inflation. Commercial real estate is a hard asset that can produce current cash flow. Owners have the ability to increase income based on market conditions, to reimburse their property-related expenses and to deduct depreciation losses on their taxes.
Commercial assets may also appreciate over the lifetime of the investment, often significantly improving investors’ long-term returns. Overall, commercial real estate may be both an attractive long-term investment and an effective hedge against rising inflation.
— Cadre is a premier commercial real estate investment platform that provides efficient access to institutional-quality deals with superior transparency and unique opportunities for liquidity. Cadre’s mission is to make commercial real estate more accessible, transparent and affordable to a greater number of investors. This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.