Investing in commercial real estate is frequently touted as a hedge against inflation, and for good reason. The key drivers behind this stability are numerous and impactful. Still, as the current inflationary climate continues to heat up, landlords must be aware of the potential pitfalls of sudden spikes in interest rates. With the economy experiencing a significant rise in interest rates over the past six months, the risk of devastating losses for landlords is too real. It's crucial to understand the factors at play and take proactive measures to protect your investments.
Commercial real estate investments are often considered inflation-proof investments. This is due to several factors. For dramatic effect we shall lay out those factors here, and then share why landlords are, or should be, quite concerned about inflation in the short term. Spoiler: sudden increases in interest rates, like what we have been experiencing the past 6 months, can cause catastrophic losses for landlords.
But first, why real estate is considered inflation proof:
- Rent Increases: As inflation rises, so do operating costs for commercial properties, including property taxes, utilities, and maintenance costs. Landlords may choose to pass these increased costs onto tenants in the form of higher rent, which can provide a hedge against inflation.
- Income Stream: Commercial real estate investments generate an ongoing income stream from rent, providing a consistent source of cash flow even during periods of inflation.
- Tangible Asset: Unlike stocks or bonds, commercial real estate is a tangible asset that can be seen, touched, and physically occupied. The physical nature of the asset can provide a sense of security, as it is less subject to market volatility than financial assets.
- Appreciation: In addition to generating an income stream, commercial real estate can also appreciate in value over time, providing a potential source of capital growth. In periods of inflation, real estate values can rise as construction materials and labor costs increase.
- Portfolio Diversification: Commercial real estate can be a valuable addition to an investment portfolio, helping to diversify investments and reduce overall portfolio risk. This is because the performance of real estate is often uncorrelated to other asset classes, such as stocks and bonds, making it an effective hedge against inflation.
- Long-term Investment: Commercial real estate investments are often made with a long-term perspective, with investors seeking to hold the property for several years or even decades. Over the long term, inflationary pressures tend to average out, providing a more stable investment environment.
- Inflation-linked Leases: Some commercial real estate leases may be tied to inflation, providing an automatic adjustment mechanism that can help to protect against inflationary pressures. For example, a lease may include a clause that provides for annual rent increases based on the Consumer Price Index (CPI).
In conclusion, commercial real estate investments offer a compelling opportunity for those seeking to protect their wealth from the ravages of inflation. The steady income stream, the tangible nature of the asset, the possibility of appreciation, the diversification benefits to your portfolio, the long-term investment horizon, and the strategic use of inflation-linked leases all combine to offer a robust defense against inflationary inflation forces. By carefully considering these factors, investors can make informed decisions and maximize their returns over the long term.
Let’s talk about risks: inflation can cause catastrophic harm to commercial real estate investors in the short term. Here are a few specific ways:
- Many landlords have long-term fixed leases but a floating rate mortgage. In these scenarios, rent does not increase as interest rates go up, but the mortgage payments do. For any building that has relatively low positive cash flow, this can be the difference between printing money and bankruptcy.
- Many large commercial real estate investors have relatively short-term mortgages, e.g. mortgages that need to either be paid in full or refinanced within 5 years of borrowing. In these cases, inflation can cause a real cash crunch, especially when interest rates are rising but the economy is not booming. This is exactly what is happening now: landlords cannot increase rent, and their mortgages are coming due. However, the only new debt available is at a much higher interest rate than what they were paying previously. This, too can be the difference between solvency and bankruptcy for a landlord.
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