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How Inflation and Interest Rates Affect Commercial Real Estate Investments
Steve Nabity
Introduction
“The value of every business, the value of a farm, the value of an apartment, the value of any economic asset is 100% sensitive to interest rates.” This is what Warren Buffet once said about interest rates. Here is what he said about inflation – “Inflation Is Never Gone It’s Always In Remission. It’s Something That Is Human-Made And Governments Can Create.” When investing in commercial real estate, understanding inflation and interest rates is critical for making informed decisions.
Interest rates and inflation impact financing costs, property values, and the rental income potential. Interest rates impact cap rates, a valuation metric used in real estate. So, acquisition and strategies are affected by interest rates. As inflation and interest rates change, they create opportunities or risks that commercial real estate investors should be alert to.
In this article, we will explore how the economic forces of inflation and interest rates impact real estate, access to capital, and investment opportunities. We will also discuss what you can do to hedge against inflation, how to think about long-term investing in an inflationary environment, and how you can stay proactive about future economic shifts.
Understanding Inflation and Its Impact on CRE
Inflation and commercial real estate have an interesting relationship. Inflation erodes the purchasing power of the dollar that you hold. It causes prices to rise including those of commercial real estate assets. Rents also go up as lease agreements may have clauses that adjust rent in line with inflation to account for the declining value of money. On the negative side, if there is no rent increase, then it results in lower returns for the landlord. Also, if the price of everything goes up, construction costs and materials become more expensive. This may reduce the margins for developers of commercial real estate. Operational expenses including salaries of maintenance folks and a property manager also go up. Higher expenses may eat into the net operating income margins delivered by a property. So, inflation has positive and negative impacts on commercial real estate.
Interest Rates and Financing Costs in CRE
Real estate is more often a leveraged asset than not. This means a lot of real estate deals are financed using debt. These loans are either fixed rate or variable/floating rate. Interest rates impact the cost of borrowing. If rates go up, new loans cost more while existing floating rate loans also become dearer. If rates go down, it becomes easier to service the debt.
If interest rates rise, then the debt service coverage needed to obtain a loan goes up. Some properties may not have high enough income to provide the necessary coverage which results in fewer borrowers being eligible for loans. If a loan is towards the end of its term, refinancing can also get difficult if the borrowing isn’t conservative.
Commercial real estate investors must recognize how interest rate impacts assets and adjust their strategies accordingly.
Inflation as a Hedge: CRE as a Safe Investment
Inflation is a reality that we all live with. It usually does not disappear and is somewhat of a permanent fixture. To hedge against this economic force, lease agreements have a clause for rent increases. Usually, landlords look to increase rents every year or every few years to keep pace with inflation.
This ability to raise the rental income of property makes commercial real estate an interesting prospect for investors during times of sustained high inflation. Real estate as an inflation hedge is possible. Stocks and bonds may not have the same ability to raise the income/dividends/yield that they provide to investors. In fact, higher costs may squeeze the profit margins of large corporations operating in industries with low pricing power. Therefore, hard assets like commercial real estate may favorably be viewed by investors looking to hedge against inflation.
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Impact of Interest Rate Hikes on Property Values
When interest rates rise, they impact the property values as well as the ability of purchasers to fund acquisitions. As mentioned above, real estate is valued based on a metric called capitalization rate or cap rate. If interest rates rise, so do cap rates. The cap rate is calculated by dividing the net operating income by the property value. So, if cap rates go up, it implies that property values have decreased.
If you think about it, the way cap rates work is logical. If it becomes more expensive to borrow due to higher interest rates, investors won’t be willing or able to pay as much for a property. They may target a higher rate of return due to higher interest rates. Even if they pay up, servicing the higher-interest debt will eat into margins. So, sellers may end up lowering their asking price to a level that provides comfort to the buyer.
Access to Capital and Investment Opportunities
Interest rates directly impact the cost of capital. So, if the cost of capital goes up due to rising interest rates, banks tighten their lending standards. This makes it more difficult for investors and developers to fund their acquisitions/projects using debt financing. If access to capital becomes difficult, projects and investments may be delayed or scrapped altogether.
Investors may be forced to find opportunities with a higher margin of safety. That may not be possible if the bidding for properties is competitive. Developers may experience their margins getting compressed if the construction cost goes up. Those investors with idle cash will be at an advantage during times of high interest rates and tight credit. They may be able to execute deals that the competition may not.
CRE Sectors Most Affected by Inflation and Interest Rates
Commercial real estate is highly sensitive to interest rates and inflation. Some sectors within commercial real estate are impacted more than others. The retail sector, for example, is perhaps the most sensitive to interest rates and inflation as higher prices tend to drive down consumer spending. Within retail, a lot depends on whether the tenants are from a consumer staples background like a grocery store, or a discretionary segment which is more sensitive to inflation.
The office segment is less impacted by interest rates than retail. However, it does get affected as rising borrowing costs weigh on the profit margins of businesses. Expansion plans and hiring take a back seat affecting the demand for office spaces. The industrial sector is, perhaps, the most resilient. There is long-term demand for warehousing as e-commerce grows. A resurgence of manufacturing in the US can also be a demand driver.
Long-Term Investment Strategies for Inflationary Times
The primary driver of income from commercial real estate is rental income. So, if investors can figure out how to increase rental income, that can act as a hedge against inflation. Leasing out commercial space on a long-term basis with rent escalations is one way to raise rents progressively over time.
If you study the macro environment closely and vaguely understand where we are in the interest rate cycle, then you may want to use a fixed-rate mortgage to lock interest rates. If you foresee rates going up, it could save you money via lower borrowing costs.
Investors can also consider looking for value-add properties where there is scope to upgrade the property to substantially raise rents over an 18 to 24-month period. Depending on how the business plan is executed, this could offset inflation to quite an extent.
Preparing for Future Economic Shifts
In order to prepare for changes in the macro environment, the first step is to stay informed about inflation and interest rates. The best way is to read the news, listen to what the central bankers are saying, and monitor economic trends from time to time. If you have financial advisors or consultants, have discussions with them on a regular basis.
One more thing you can do is attend real estate conferences, hear what real estate professionals are saying, or sign up for newsletters from real estate professionals. Being aware of key events and information will allow you to make informed decisions.
It is also important to be flexible with your investment strategies. If economic shifts call for a change in the investment approach, then one has to be open-minded about adapting and adjusting to the new realities. Diversifying portfolios and looking for alternative assets can keep risk levels manageable.
Conclusion
We have discussed inflation and commercial real estate, interest rate effects on commercial real estate, and the role of commercial real estate as an inflation hedge. We looked into how increased financial costs in real estate can become a challenge. We briefly touched upon investment strategies during inflation and how you can stay informed about important macroeconomic trends.
We encourage you to learn more about commercial real estate investing by checking out specially curated content here. Feel free to schedule an introductory call with us to discuss anything related to real estate investing. We wish you good luck creating the right investment strategy to achieve your financial goals.
