Inflation's Effect on Commercial Real Estate Investments

In this hyper-inflationary time, the old adage is that real estate is a great hedge against inflation, because as the value of the dollar decreases, a hard asset does not, right? Not necessarily - except for multifamily - where you can reset the rental rate on an annual basis and tie it to inflation. As a result, multifamily investments continue to be a market darling. But for all other asset types, consider two trends:

First, inflation can hurt existing owners. Consider the absolute NNN retail investment whose lease term is twenty years. These leases often have a small rent escalator, oftentimes no more than 2 percent per year. Sometimes there is no escalator at all. If the lease calls for 2 percent annual escalations and we experience two years in a row of 10 percent inflation, all of a sudden, the landlord's gross income is 16% behind where it should have been.

Second, inflation can hurt new buyers. Shown below in three different ways, buyers of commercial real estate are facing significant cap rate compression: 

For non-multifamily properties, buyers should consider searching for properties with upcoming lease expirations that will allow for a re-set of the rental rate. But for properties that are subject to a long-term lease whose rate does not tie to the consumer price index, the result has been cap rate compression. In other words, a lower rate of actual return due to inflation has not pushed purchase prices down to maintain an equivalent cap rate. Instead, the purchase price has gone up and the net income has held steady. So far, due to the strength of the economy, sellers have prevailed. But as interest rates increase and the cost of capital may exceed the rate of return, will cap rate trends turn a corner? We will keep you posted.