Caleb Richter, CEO of MyEListing.com.
Whether inflation first entered your adult life in the 1980s, the late 2000s, or the early 2020s, the aftermath is more or less the same: empty wallets and angry consumers. And while some inflation is good (like that of the Federal Reserve) annual target of 2%), that’s not too much of course.
Amid all the commentary usually associated with bloated economies, you might hear the word “hedge” floating around a few times. And while many asset classes can help you hedge against inflation, how can you use commercial real estate (CRE) as a hedge specifically?
How Inflation Degrades National Currency
In bloated economies, your average consumer ends up paying more for everyday items and conveniences than what might be considered average due to diminished purchasing power.
Purchasing power in this context refers to the value of something that you can extract with a single currency (such as a single US dollar). In bloated economies this decreases, and vice versa for deflation.
To illustrate reduced purchasing power
This decline in purchasing power can be easily illustrated with a simplified example. Let’s say John Doe usually pays $100 a month for groceries in a regular economy. And let’s say a major financial crisis just crippled that economy. As a result, consumers, now driven by fear of the unknown, are spending less and saving more.
However, companies in John Doe’s country still need to make a profit, but this drop in consumer demand ultimately leads to shrinking profit margins. So these companies are starting to raise their prices to compensate.
And these price increases accelerate even more when those companies start paying more for raw materials and labor as a result of this financial crisis, creating a domino effect.
All this leads to an inflation of roughly 9%. This means that if something cost $1 last year, it costs $1.09 now. Each unit of that economy’s currency has lost 9% of its purchasing power, and John Doe will now pay $109 a month for groceries for exactly the same things.
What does inflation leave behind?
Ultimately, what inflation leaves behind is that the average consumer has to pay more for everyday goods and services through no fault of their own. And while inflation can arise as a direct result of high employment and strong economic growth, there are many things that come into play in a large, complex economy, such as price inflation or consumers getting better-paying jobs. More impactful are the consequences of macroeconomic factors such as global conflicts, financial crises and large-scale natural disasters.
Hedging against inflation
To hedge against inflation, you store your money in assets that increase in value over a period of time. Shop here is a synonym for buy. Gold is probably the most popular example of an inflation hedge. As the purchasing power of the US dollar declines, an ounce of gold usually becomes more expensive as more investors buy it.
As such, the owner of that gold has successfully hedged against inflation. They can sell that asset and receive more dollars in compensation than they originally invested, compensating for the decline in that currency’s purchasing power.
How can commercial real estate hedge against inflation?
Commercial real estate works in a similar way to gold in inflationary environments. As the purchasing power of a currency falls, the average value of real estate along with new and existing commercial rents rises as lease renewal rates rise.
This is largely the case with properties that have already been developed and have existed for a longer period of time. It’s likely that interest rates on loans taken out to buy those properties were lower before inflation hit.
As soon as the Federal Reserve kicks in raising interest rates to fight inflation, the cost of owning the property for the owner remains the same while its value increases. However, this does not apply so much to properties that are currently or under development. Inflation often leads to higher costs for labor and materials, slowing down real estate development.
This means that the demand for existing real estate is rising and the demand for new real estate is falling, making the odds all the more in favor of existing commercial property owners.
Commercial real estate as a short-term hedge against inflation usually doesn’t bode as well as its long-term alternative. Your investment takes time to mature, and buying CRE when it’s too late won’t protect your portfolio in the same way.
This is largely due to the rising costs of goods, services and labor that accompany inflation, especially when it accelerates rapidly. By the time you consider putting some money into CRE in a bloated economy, not only will it be more expensive, but it’s usually too late.
Instead, you should approach investing in CRE as a long-term hedge. Now that we are out of these inflationary times, once you are able, now is a good time to research investment strategies and talk to the right professionals to get you started; the last thing you want to do is wait too long.
Selecting the best home type
Selecting the best types of commercial real estate as a hedge is what market specs really take into consideration. Take the Covid-19 pandemic for example; the virus sets a lot of stores bankrupt, but led to a scorching hot housing market.
Those investing in retail stores felt the aftershocks of the pandemic as retail values plummeted, while those investing in multifamily and industrial real estate saw the exact opposite.
This is extremely important information to keep in mind on the road to a post-pandemic economy. The retail market has changed forever, and while consumers still enjoy personal shoppingThere’s no denying that the pandemic has taught us cold lessons about e-commerce. In the end, do your research and stay diligent in investing in CRE.