We’ve all noticed the change — at the supermarket, gas pumps, and nearly everywhere else. Whether it was the cost of your Christmas tree or your New Year’s Eve champagne, prices are significantly higher today than they were just one year ago. In fact, the Consumer Price Index has climbed 6.8% in just the last year, the largest inflationary jump the U.S. has seen since 1982.
Initially, the Federal Reserve had categorized our current economic situation as “transitory inflation.” In other words, a temporary and predicted result of the pandemic and its impact on our economy. In the last month, however, Fed Chairman Jerome Powell has admitted that our current inflation will likely last longer than initially anticipated.
With the knowledge that we may need to endure inflation for longer than expected, it’s time to examine how inflation could impact commercial real estate.
Real Estate as a Hedge Against Inflation
Many investors purchase real estate and other tangible assets to hedge against inflation. While most investments, including stocks, tend to react negatively in inflationary conditions, the value of property reacts proportionally to the inflation rate and appreciates as inflation climbs. In other words, if you have a loan on a commercial property, and have locked in a low interest rate on that loan, the value of your property will continue to rise with inflation, even as your cost remains the same.
Knowing the relationship between inflation, costs and interest rates allows us to make other predictions about the impact of inflation on commercial real estate.
The impact of Supply and Demand on Leasing
Our economy is influenced by countless factors, including supply and demand. Some of our current inflation has been caused by the supply chain issues that have plagued the globe for well over a year. When materials and products are scarce, prices of those items increase. And when prices increase, typically the cost of labor also escalates.
Increasing labor and material costs could force some developers to put the brakes on building new properties. As a result, demand for existing properties would then climb, and property owners would be able to raise rental rates.
At the same time, we could also expect to see owners offering shorter-term leases. While a shorter term doesn’t offer owners the same stability in occupancy over time, it does provide owners with the opportunity to adjust rental rates more frequently and take advantage of the increased demand for their space.
The Impact of Inflation and Interest Rates on Market Share
Just as increased costs make it more difficult for developers to build, increasing interest rates will make it more difficult — or at least less advantageous —to borrow money. The Federal Reserve is expected to raise interest rates as many as three times this year and anticipates raising rates at least three more times by the end of 2024. The combination of higher inflation and higher interest rates will not only cause developers to build less, but existing property owners will likely choose to hold on to their assets.
In a rapidly developing real estate market, property owners lose market share every time a new building opens its doors. However, when development slows, owners maintain their market share. Again, this will give owners the upper hand when setting rental rates and terms.
How Long will These Conditions Last?
Just as it has been difficult to predict how long the coronavirus pandemic will last, it is also a challenge to forecast how long our pandemic-influenced economic conditions will prevail. It has become apparent that inflation is not just a transitory blip on our economic radar, and we’ll be dealing with the repercussions of rising prices for at least another year.
While some of us who recall the economy in the 1970s are anxious about our current conditions, history is unlikely to repeat itself in another “Great Inflation.” The economic drivers behind our current conditions are different from those in the 1970s, and economists are better prepared to manage inflation than they were 40 to 50 years ago.
The Fed will attempt to temper inflation through adjustments in interest rates and reduced bond purchases. However, Fed Chairman Powell has acknowledged that our high consumer prices will continue well into summer 2022, and investment group Goldman Sachs is projecting that inflation will get worse before conditions begin to improve. But for those who currently hold commercial real estate and those who are considering adding property to their investment portfolios, our current economy could provide opportunity.
This is part one of a two-part series examining the impact of inflation on commercial real estate. Read part two here about how inflation could influence the workplace.
Content and strategies shared on NAIOP blog posts are intended to provide information and insights to industry practitioners and do not constitute advice or recommendations. NAIOP and its presenters disclaim any liability for actions taken as a result of these blog posts.