Inflation, in simplest terms, can be defined as a sustained increase in prices of goods and services. It is measured in an annual percentage rate which depicts how much lesser in value your dollar will be in the current year as compared to previous y
Commercial Real Estate and Inflation
In commercial real estate, inflation leads to higher cost for raw material, labor, municipal services, insurance and rent. The price of everything will increase, including the value of a commercial real estate property. As expenses rise, the net operating income (NOI) decreases. The debt payment is fixed - so when NOI drops, the return on investments also falls because the fixed debt payment has to be made out of your pocket.
A rise in the interest rate is also expected during inflation, resulting in higher mortgage costs and capitalization rates, thus decreasing commercial real estate value. The new NOI will be valued at the higher capitalization rate. The return on investment will drop and the property must be held for longer just to get back the principal amount.
Commercial Real Estate as a Hedge Against Inflation
It is common for investors to use commercial rest estate as a hedge against inflation. During inflation, the quantity of land is fixed and there is more circulation of money in the economy, so the price of commercial real estate will rise (demand-pull inflation).
When markets are in "equilibrium", the low vacancy rates give negotiating power to the landlord who can sign a contract with the tenant to generate rent which will increase simultaneously with inflation or pass the increase in operating expenses to the tenant. However, when the vacancy rates are high, the power is in the hands of the tenant to move rather than sign a deal which will show signs of escalation provisions with an increase in inflation. In the latter case, commercial real estate does not provide a hedge against inflation.
What to Look for In a Commercial Real Estate Property during Inflation?
In one word - location. Commercial real estate investments will be highly profitable during inflationary period if a well situated asset is bought at a sensible price. Characteristics critical to a good location include employment opportunities, population growth rate and transportation means.
The key to profitability in commercial real estate investment during inflation is to construct portfolios that take into account supply excesses which tend to weaken the hedging quality of commercial real estate. In past years, commercial real estate has successfully beaten inflation except in situations of severe surplus as a result of too much construction or lack of demand. However, such surpluses are infrequent on a national level. Imbalance is more prevalent in the local market characteristics. Investors should focus on these characteristics to develop commercial real estate portfolios that ensure returns on investment along with overcoming inflation.
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