The Impact of Inflation on Real Estate Asset Classes with CEO, Jilliene Helman

FAQ written on old typewriter.

FAQ written on old typewriter.

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In case you missed the livestream. Discover how you can potentially better navigate this unpredictable investor environment by checking out the transcript from this discussion between RealtyMogul CEO, Jilliene Helman and Investor Relations Managing Director, Brian Sigler.

1. What are the main drivers of inflation:

  • Inflation is a loss in purchasing power. Your $1 today can buy you more goods and services than your $1 tomorrow.
  • There are a couple primary causes for the inflation we are seeing today. One is the sheer amount of money that the Federal Reserve printed in response to Covid. During the pandemic, the Federal Reserve began a series of stimulus measures, including buying bonds and pumping a ton of money into the economy. As of February 2022, the central bank had increased the nation’s M2 money supply by 40% over the last two years – that’s an enormous amount of printing. The other is disruptions in supply chain. Covid stifled demand and companies pulled back accordingly. Now they’re being asked to ramp as rapidly as possible and it takes time for those gears to turn quickly - I’m reminded of the basics of physics - objects in motion tend to stay in motion. The supply chain got derailed and so it takes more inertia to get it cranking again.
    • It took us almost 2 years in Covid to get to this point, so it’s not unrealistic to think it takes 2 years for the supply chain to normalize but I do think a lot of the inflation caused by supply chain issues is transitory.

2. How do different asset classes react to inflation?

  • If you look at history, real estate assets have on average historically performed better than other asset classes. But within real estate, there is variability so let’s run through it asset class by asset class.
  • First, I think the strongest hedges against inflation within real estate are found in housing – namely apartment buildings. This is because they have comparatively shorter lease terms, so you can reset those rental rates to the new inflationary normal more quickly. The shorter the lease term, the faster you can charge new rents commensurate with inflation.
  • Most of the shorter term leases are in housing - multifamily, student housing, senior housing. But I personally think multifamily is a better inflation hedge than student housing or senior housing because inflation is not only on the revenue side of the equation, it’s also on the expense side of the equation. What I mean by that is – take senior housing as an example, Senior housing has greater opex than traditional multifamily. You might offer amenities like a fully staffed kitchen, or somebody who drives tenants to the grocery store or the doctor – wage inflation will increase expenses and there are still labor shortages around the country. The other issue in senior housing is affordability. Many of the tenants are on a fixed income – like social security – so they may not be able to stomach big increase in rent if their social security payments are not going up.
  • The other benefit to multifamily during times of inflation is increased borrowing costs makes it more expensive to buy a home, which could increase demand for multifamily tenants
  • And increased cost of development may limit the supply of new housing that is built, which could lead to more demand for existing assets and increase rental rates at existing properties
  • NOW, before we chat about other asset classes, let me give you a big caveat with multifamily- local politics can sometimes get in the way, particularly with rent control. For example, the NYC rent board just voted to approve a 3.25% rent increase - that’s with inflation marks coming in above 8%. So there are some times when government intervention gets in the way and you’ll want to understand that nuance in certain markets, typically those markets that have more liberal rental laws where you can’t increase rents to what the market could sustain during the inflationary period due to government intervention.
  • Self-storage is another asset class where you can raise rents quickly. Many self-storage contracts are month-to-month and they tend to be sticky tenants – it’s a pain to move out of a self-storage facility and most folks will stomach the rent increase.
  • Hospitality is another one where you can rapidly increase rents as most of these are nightly rentals, so this makes hotels an attractive inflation hedge. But the flip side is the high expense load and cost of labor – similar to in senior housing, you have a lot of employees operating that hotel – as wages increase, expenses increase. There are also other operating expenses that are growing with inflation. So net net, you get the benefit of increasing nightly rates almost immediately, but you’re burdened with additional costs.
  • Outside of housing, self-storage and hospitality, the other major asset classes are industrial, office and retail.
  • When it comes to industrial, industrial has been a shinning star the last few years with Covid rampant and consumer behavior shifting to more e-commerce. Despite this, industrial leases can be problematic as a hedge against inflation because they are typically locked in for 5-10 years, you cannot reset that rental rate annually like in multifamily or nightly like in hospitality. However, most industrial leases are what are called NNN, which means that the tenant pays all the expenses including operating expenses, taxes, insurance and any maintenance. So as inflation increases and these expenses go up, the landlord or the investor is not eating these expense increases – the tenant is paying them. So you don’t get to reset the revenue side of the equation, but typically you’re also not burdened by additional expense.
  • Up next is office and retail and for these asset classes, it really depends on the type of lease – certain leases – typically in retail assets - will include CPI rent adjustments where the rent escalates based on a pre-determined measure of inflation. So even though the lease term is not resetting, the rental rate is. These types of leases can be very beneficial in inflationary time periods assuming the tenant can actually absorb that increased expense. You might see other leases that are NNN, where the tenant absorbs all the increase in expenses. In office and medical office, you may see shorter lease terms like 3-5 years, which would allow you to reset rental rates faster than a 10-year term.
  • And last on the list is single tenant net lease deals. These are typically NNN leases, so you get the benefit of the tenant absorbing the increase in expenses, but typically these lease terms can be very long 20 or 30 years. Most often, they have predetermined increases in the rental rate of 2-3% so if inflation is 8% a year and you’re only getting 2-3% rent bumps, you’re losing out on a lot of the upside.

3. Why might more leverage make sense in an inflationary environment? What’s best in a time like this, fixed-rate debt or floating-rate debt?

  • It depends.
  • As we look forward, to make the decision if it’s better to have fixed-rate or floating-rate debt, there are two primary questions:
    • 1) what do you believe will happen? If you believe that the Fed is going to overshoot and increase rates too high, the economy is going to plunge into a deep depression, and the Fed will come back quickly and pump more money into the economy and rapidly decrease rates, floating-rate debt is not such a bad idea. You don’t have the same lock ups in floating rate debt as you do in fixed-rate debt - typically called prepayment penalties or defeasance where you owe the lender a certain amount of minimum duration or minimum interest -- so you will be able to refi if rates drop again, which may not be such a bad idea. On the flip side, if you think the Fed is going to keep increasing rates and increasing rates, you’re better to lock in fixed-rate debt today so you’re not paying more for that same debt as rates increase.
    • 2) what is your strategy for the asset? There are some assets even in today’s environment that you can add meaningful value to quickly. And once you add that value, you can refinance. This is likely a more heavily levered strategy, but leverage makes a lot of sense in an inflationary period.
      • Why?
      • Well, in an inflationary period, your dollars are worth less tomorrow than they are today. So you’re going to get debt today, but you’re going to pay that debt back with dollars that are worth less and what is usually the easiest asset class to lever? Real estate.
    • Floating rate debt also typically gives you higher leverage than fixed-rate debt as fixed-rate lenders have more stringent DSCR coverage requirements. And debt makes a lot of sense in times of inflation.
    • All that being said, some investors may prefer fixed-rate debt because it can afford them the opportunity to sleep well at night. If a deal works and you’re satisfied with the projected returns with fixed-rate debt and it’s a longer term business plan, many investors feel this is a safer strategy because there is less variability and less opportunity for something to go wrong. Today most fixed-rate debt I see is lower leverage than floating rate and although it’s not optimizing for an inflationary period, lower leverage is viewed as safer than higher leverage.

The content is for informational purposes only and should not be regarded as a recommendation, an offer to sell, or a solicitation of an offer to buy any security. The information discussed in the webinar may include forward-looking statements; forward-looking statements, hypothetical information, or calculations, financial estimates, and targeted returns are inherently uncertain. Any information contained herein has been secured from sources we believe are reliable, but we make no representations or warranties as to the accuracy of such information and accept no liability therefor. No part of this video is intended to be binding on RealtyMogul or to supersede any issuer offering materials. All opinions expressed herein are solely those of the speaker and do not represent those of RealtyMogul or any of its affiliates

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