Whether inflation first entered your adult life in the 1980s, the late 2000s or the first few years of the 2020s, the aftermath is more or less the same: emptied wallets and angry consumers.
And while some inflation is good (like the Federal Reserve’s annual target of 2%), too much is obviously not.
Amidst all the commentary that usually accompanies inflated economies, you may hear the word “hedge” thrown around quite a few times. And while many asset classes can help you provide a hedge against inflation, how can you utilize commercial real estate specifically as a hedge?
How Inflation Degrades National Currencies
In inflated economies, your average consumer ends up having to pay more for everyday items and conveniences than what may be considered average due to decreased purchasing power. Purchasing power, in this regard, refers to how much value of something you can extract with a single unit of currency (such as a single US dollar). In inflated economies, this decreases, and vice versa for deflation.
Illustrating Decreased Purchasing Power
This fall in purchasing power can be simply illustrated with a simplified example. Let’s say John Doe usually pays $100 a month for groceries in a regular economy. And let’s say that a large-scale financial crisis has just crippled that economy. As a result, consumers, now driven by fear of the unknown, start spending less and saving more.
Businesses in John Doe’s country, however, still need to make a profit, but this decrease in consumer demand is ultimately shrinking profit margins. So, these businesses start raising their prices to compensate. And these price increases accelerate even more when those businesses start paying more for raw materials and labor as a result of this financial crisis, creating a domino effect.
All of this creates an inflation rate of, say, 9%. This means that, if something cost $1 last year, it now costs $1.09 today. Each unit of that economy’s currency has lost 9% of its purchasing power, and John Doe will now pay $109 a month for groceries for the very same things.
What Does Inflation Leave Behind?
Ultimately, what inflation leaves behind is your average consumer having to pay more for everyday goods and services at no fault of their own. And while inflation can come about as a direct result of high employment and strong economic growth, there are a myriad of things to factor in a large, complex economy like price gouging or consumers getting higher-paying jobs. More impactfully are the consequences of macroeconomic factors such as global conflicts, financial crises and large-scale natural disasters.
Hedging Against Inflation
To hedge against inflation, you store your money in assets that appreciate in value over a certain period of time. Store here is a synonym for purchase. Gold is probably the most popular example of a hedge against inflation. As the purchasing power of the U.S. dollar falls, an ounce of gold tends to become more expensive as more investors buy it.
As such, the owner of that gold has successfully hedged against inflation. They can sell off that asset and receive more dollars in compensation than they originally invested, compensating for the drop in that currency’s purchasing power.
How Commercial Real Estate Can Hedge Against Inflation
Commercial real estate operates in a similar way to gold in inflationary environments. As the purchasing power of a currency drops, average property values tend to increase alongside new and existing commercial rentals as lease renewal rates increase. This is largely the case with properties that are already developed and have been around for some time. It’s likely that the interest rates on any loans taken out to purchase those properties were lower before inflation hit.
Once the Federal Reserve begins raising interest rates to combat inflation, the cost of owning the property for the owner stays the same while its value grows. This is not so much so, however, for properties currently or planning to be under development. Inflation often leads to increased costs for labor and materials, slowing down property development as a result. This means that demand for existing properties rises while demand for new ones falls, placing the odds all the more in favor of existing commercial real estate property owners.
Commercial real estate as a short-term hedge against inflation usually doesn’t bode as well as its long-term alternative. Your investment needs time to mature, and purchasing CRE when it’s too late will not protect your portfolio in the same way.
This is largely due to the rising costs of goods, services and labor that come with inflation, most especially when it rapidly accelerates. By the time you start considering putting some cash in CRE in an inflated economy, not only will it be more expensive, it’s usually too late.
Instead, you should approach investing in CRE as a long-term hedge. As we get out of these inflationary times, now is a good time, as soon as you’re able to, to look into investment strategies and talk to the right professionals to help you get started; the last thing you want to do is wait too long.
Selecting The Best Property Type
Selecting the best commercial property types as a hedge is where market specifics really come into account. Take the Covid-19 pandemic, for example; the virus put many retail outlets out of business but led to a flaming hot housing market. Those invested in retail felt the aftershocks of the pandemic as retail values plummeted, while those invested in multifamily and industrial real estate saw quite the opposite.
This is extraordinarily important information to keep in mind moving forward into a post-pandemic economy. The retail market has forever changed, and while consumers still enjoy shopping in person, there is no denying the cold lessons the pandemic taught us about e-commerce. In the end, do your research and stay diligent when investing in CRE.