Inflation and Its Impact on Real Estate Investing

A Person looking investing dashboard via laptop

Inflation is at the highest level in over four decades and understandably, the recent economic environment has caused quite a stir.

No one will fully escape feeling the impact in one form or another, which is why it is important for all investors to understand how these events affect their  financial situation and that they feel empowered to make informed decisions. When discussing inflation and the Consumer Price Index (CPI), however, the data can become overwhelming, and it is not always apparent how to navigate the investment landscape during periods of high inflation. So, as we discuss inflation and CPI, we hope to provide not only an overview of the effects on investors, but also some relevant investment strategies for elevated inflation conditions, and insight into how commercial real estate investments can fit into this strategic framework. 

Questions about inflation in a blue box

Ultimately, inflation is a loss of purchasing power. 

A dollar today can buy more goods and services than that same dollar will be able to buy tomorrow. CPI is a measure of inflation that is representative of the average consumer’s spending habits as calculated monthly by the U.S. Bureau of Labor Statistics, which also tracks the pace of change in CPI. Over the last 12 months ended August 2022, CPI inflation increased by 8.3%,1 a rate that far outpaces the Federal Reserve’s average target of 2.0%2 per year. There are many contributing factors to the inflation we are experiencing today, but the primary drivers are the Federal Reserve’s response to Covid, supply chain disruptions, a tight labor market and volatile energy prices. Appreciation of real estate has no doubt played a large part in inflation as well.

With the goal of avoiding a massive recession during the Covid-19 pandemic, the Federal Reserve began a series of stimulus measures, including purchasing debt securities (also known as quantitative easing), cutting the target federal funds rate, and pushing significant amounts 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.3 As a result of these measures, the Federal Reserve was able to drastically stimulate the demand side of the economy. However, the supply side of the economic equation is a different story. At the beginning of the pandemic, supply chains worldwide pulled back dramatically, due to expectations of stifled demand, material shortages, and shipping and labor disruptions. Though demand has since rebounded, many of these disruptions are still factors, and supply has yet to fully catch up in certain segments of the economy. The resulting imbalance between supply and demand depleted inventories, created supply chain bottlenecks and became one of the most dramatic drivers of inflation (i.e., too many dollars chasing too few goods). The effects of rising energy costs, due to a lag in production in the face of renewed demand and Russia’s invasion of Ukraine, cannot be discounted either. The energy index increased by 23.8% year-over-year through August 2022.1 Although this is a smaller increase than in July, this change impacts consumers both directly at the gas pump and indirectly by driving up the prices of everyday goods via increased input and transportation costs.

Bullet points with a hundred dollar banknote background

In direct response to inflation, the Federal Reserve has now increased the federal funds rate five times in 2022, bringing the target fed funds rate to 3.00-3.25%, the highest level in 15 years. This year has seen a total increase of 3.0% in the target,4 in an effort to curb demand and bring supply and demand back closer to equilibrium. This has been the fastest pace of tightening since the 1980s5 and has fueled much discussion about whether corresponding rising interest rates will trigger a recession. It is important to note that the federal funds rate is still nowhere near 2000’s levels of 6.5%, much less the nearly 20% high of 1980.6,7 Rather, it is back to pre-pandemic levels and still well below the current level of inflation. There is much debate as to whether inflation will continue to rise or fall. In August, overall energy prices decreased by 5.0%, while gas prices specifically decreased by 10.6%.1 Richard Barkham, Global Chief Economist for CBRE, shared his view in the CBRE 2022 Mid-Year Global Real Estate Outlook that “we’ve reached the peak of inflation,” believing it will “ease over the next 6, 12, 18 months” such that “by the middle of 2023, that will allow the fed and the other central banks around the world to start cutting interest rates so demand can revive.”8 But only time will tell whether we have seen inflation peak or whether inflation is set to remain stubbornly elevated for a longer period of time. The most recent CPI report in September showed a monthly change in the core CPI of 0.6%, which equates to an annualized rate of 7.4%. This month’s higher-than-expected inflation print had many questioning whether we’re actually at the peak of inflationary pressures. The 75 basis point hike this week is the Fed’s signal that they’re going to try to make sure it is.

Questions about market context and property types in a blue box

Periods of high inflation tend to affect asset classes differently.

The very benefit of fixed income securities, which are investments intended to produce a stable income stream, can become a detriment in periods of high inflation. The fixed nature of interest generated by these securities means that rising inflation erodes the purchasing power of the coupon payments and future repayment of principal, often causing bond prices to fall when inflation increases. For the stock market, high inflationary periods can lead to volatility, as higher interest rates generally translate to higher discount rates for valuing equities. During periods of U.S. history when 10-year CPI inflation averaged even just 4% annually, S&P 500 valuations at the end of those 10-year periods were always at or below historical norms.9 Real estate has, on average, performed better than other asset classes. In fact, a 43-year review of the NCREIF Property Index reveals that private real estate returns remain strong even during periods of high inflation and high/medium GDP growth.10 Unlike traditional fixed income securities, and with generally lower volatility than seen in the stock market, private real estate can offer dynamic cash flows and potential for insulation from rising expenses during periods of high inflation.

The ability to quickly reset rents to market rates, being able to adjust revenue, is an important part of the real estate inflation hedge equation for certain types of real estate. Likewise, certain types of real estate can have lease structures that provide contractual insulation from rising expenses. Self-storage and residential real estate are some of the most inflation-resistant asset classes due to the comparatively short-term nature of their lease terms. Historically, some of the strongest hedges against inflation within real estate can be found in housing – specifically, multifamily, student housing, and senior housing.

Multifamily office buildings and hotel interior

However, multifamily is often seen as a better inflation hedge than student or senior housing, because multifamily is less exposed to the expense side of the equation. Senior housing has greater operational expenses than multifamily, so wage increases and labor shortages have a greater impact, and many tenants are on a fixed income that limits their ability to absorb rent increases. Another benefit to multifamily in a high inflation environment is that increased borrowing costs to buy a home often mean that first-time home buyers are forced to rent for longer. Increases in the cost of development may also contribute to a limited supply of new housing, thus driving up demand and increasing rental rates at existing properties.

Hospitality is another property type where rents can be adapted rapidly, as rents can be reset daily. However, these properties are also burdened by very high operating expenses and are especially sensitive to increases in labor costs.

Office and retail leases often include contractual rent adjustments aimed to keep up with inflation, which means that rent will escalate regardless of the length of the lease terms. These types of leases can be very beneficial in inflationary periods, assuming that the tenant is able to absorb the increase in rent. Many of the scheduled rent increases were also set during periods of much lower inflation over the last 20+ years, so these adjustments do not fully offset unanticipated high inflation. Other leases for office and retail may be triple net (NNN) with shorter 3-5 year terms. NNN leases pass the burden of operational expenses, taxes, insurance, and maintenance to the tenant. So, even if a longer lease term precludes the adjustment of rents to market rates, properties with NNN leases are shielded from increases in expenses caused by inflation, as tenants directly bear those increases.

Question about effects of inflation in a blue box

The repercussions of high inflation are keenly felt by sponsors, as they are some of the first to see the impact of both the causes of inflation and the levers used to curtail it.

Generally, increased interest rates have a direct effect on sponsors because of the ramifications they can have on real estate valuations and debt financing. Valuations are impacted because of increases in returns from competing investments, whereas increases in interest rates make debt both more expensive and less available for new acquisitions. Diminished distributions are another factor for properties with floating rate debt. As interest rate caps become more expensive and additional revenue is required to service floating rate debt, or even increased lender reserves as lenders require a greater cushion, there is less cash flow available for distributions to investors. Another hallmark of inflation often seen by sponsors is the increased costs of materials and labor. These combine to make expenses associated with value-add opportunities higher; however, they also impact the ability to build new products. So, this is typically favorable for the valuation of existing properties, as replacement costs are a key valuation metric used by acquisition groups and appraisers.

During the most recent period of high inflation in U.S. capital markets, the cost of debt has risen by around 200 basis points (2%). This has already pushed out cap rates on some assets and, where cap rates have been more sticky, has resulted in properties with higher growth potential being acquired with negative leverage (i.e., cost of debt is higher than the going-in cap rate). Among many investors, there is the expectation that rates will start to fall by the middle of 2023. The opportunity for sponsors to buy quality assets at “discounted” values may not last long.

Additionally, multifamily has seen an historic increase in rents nationwide. Many of the key drivers of inflation, higher residential home values, higher mortgage costs, and wage growth, are largely the cause. Because the costs to purchase a home have gone up dramatically, many people have been priced out of the market and are renting for longer. Incomes have largely kept up with these rent increases, suggesting these realized rent increases are sustainable for Class A and Class B products in particular. Industrial, self-storage, and hospitality have also seen increases in rents. While office has had some rent increases, occupancy is down in most markets due to greater work-from-home and hybrid work structures. Sponsors are therefore utilizing technology where possible to mitigate increased labor costs and are looking for markets where rent increases have not outpaced incomes dramatically to take advantage of these increased rents and mitigate the effect of inflation in expenses.

In summary text in blue box

The current inflationary environment is clearly impacting the purchasing power of consumers, capital markets and the investment landscape.

While real estate and private assets have historically proven to perform well relative to the broader market indices in past inflationary periods, individual investors still must decide where specifically to allocate their capital.

The RealtyMogul Platform seeks to empower investors by providing access to institutional quality private real estate opportunities spanning a wide range of property types and geographies across the country. Turbulent markets and the current inflationary picture may present the opportunity to capitalize on specific investments in real estate. Understanding the historical context of inflation’s impact across the spectrum of the macro market from real estate to the individual consumer, while focusing on specific trends seen at the front lines by real estate sponsors, can help you make more informed and productive investment decisions.

This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward-looking statements. Forward-looking statements, hypothetical information, calculations, financial estimates and targeted returns are inherently uncertain. Past performance is not necessarily indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and RealtyMogul recommends that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment.

1https://www.bls.gov/news.release/cpi.nr0.htm

2https://www.federalreserve.gov/faqs/economy_14400.htm

3https://www.realtymogul.com/knowledge-center/article/impact-inflation-real-estate-asset-classes-ceo-jilliene-helman

4https://www.federalreserve.gov/monetarypolicy/openmarket.htm

5https://www.bankrate.com/banking/federal-reserve/history-of-federal-funds-rate/

6https://fred.stlouisfed.org/series/FEDFUNDS

7https://www.jpmorgan.com/commercial-banking/insights/rising-interest-rates-effect-on-commercial-real-estate

8https://www.cbreexcellerate.com/article/2022-mid-year-global-real-estate-outlook

9https://www.hussmanfunds.com/comment/mc220707/

10https://irei.com/wp-content/uploads/2022/06/2022-Market-Outlook-Private-RE-as-a-Hedge-Against-Inflation-Final-1.pdf


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