Inflation can be summarized as the decline in the purchasing power of a currency. In other words, it can also mean that the average price of a set of goods and services in an economy increases over time.
Since the same amount of money actually buys less goods and / or services, the investments that are supposed to help in the growth of wealth are defeated in their primary purpose. It is therefore all the more important to have investments that are well protected from inflation. Commercial real estate (CRE), as a type of asset, is quite isolated from the vagaries of the market but does it protect an investor from the fatal blows of inflation?
Inflation trends relative to commercial real estate
To understand why commercial real estate is such a resilient asset, it is imperative to know the basics of this investment. Any commercial property, whether it is as small as a two-story mall or as large as an industrial warehouse, has its lease terms as its main advantage. While allowing tenants to be assured of a long-term commitment to conduct their operations, the lease agreement also allows investors to also be confident that a long-term investment in this area is not going to go wrong.
Since inflation is a time sensitive phenomenon, long-term investments are particularly important. There have been a dozen periods of inflation in the Indian economy, but the worst cases in history have undoubtedly been in 1991 and 2008, when the inflation rate hit double digits. However, if the prices of commercial real estate can be observed during the same period, while there is an initial decline, there is also a fairly rapid recovery.
Even during the uncertain times of the 2020 pandemic scenario, the commercial real estate market was among the few investments that remained rather isolated from market volatility and started on a recovery path much earlier. These quick payback times for this asset class are the main reason investors flock to CRE’s assets.
High inflation should be on the watch list of any prudent investor, as it can seriously undervalue any investment, as well as cause a dent in future cash flow. Therefore, investments must be such that they generate returns above the current or expected rate of inflation. Let’s try to understand this through an example.
From a very simplistic point of view, suppose the current inflation rate is around 5%. This would mean that investing in any asset that yields less than 5% actually results in a loss of their purchasing power every year, relative to inflation. This would include even the safest and most basic investments – term deposits. Even other safe investments like money markets and debt can also suffer from this loss. The only hope is that in the long run the inflation rate may stabilize and investments will start to provide positive returns.
Despite this, in the long run, if the investment is left as is, the investor’s capital is able to buy less as the cost of goods and services has increased at a faster rate than the returns provided by their investments. .
To prevent such a scenario from occurring, assets must have a rate of return greater than current or future inflation rates, at least to the point where the returns generated are not negative. Most inflation rates will continue to rise – the reasons are diverse and complex.
The only question that remains is whether a slight drop in the inflation rate is only temporary or marks the start of a more protracted rise in prices. Regardless of this, it is important that investors prepare to adjust their investment strategy to protect against inflation.
Commercial real estate hedges against inflation
CRE can protect investors from inflation in three main ways. Let’s look at each of them individually.
Increase in rental income during inflation
Rising inflation contributes to rising prices. It is a given fact. The rise in prices also includes the rise in rents for commercial properties. Rising rental rates for properties while operating expenses remain relatively stable are contributing to positive property values.
However, this can lead to an increase in net operating income, which will further increase the value of the properties. As long as this value is greater than the rate of inflation, the investor’s investment will not be hampered if he holds CRE.
The rental factor
Commercial building leases are structured to increase rents at regular intervals throughout the term of the lease. An agreement, for example, could contain a clause providing for an increase in rent at the rate of 2-3% per annum.
Depending on the property, market demand and supply, the clause for different assets will be different. As long as these steady increases exceed the rate of inflation, the relative return will remain positive.
It is obvious that space will always continue to shrink. As more and more houses, apartments, buildings are created to increase the real estate supply, this conversely also creates a scarcity of space. Businesses will continue to grow and more businesses will continue to open, the need for commercial real estate will continue to increase.
In dense real estate markets and shopping malls, high demand and limited supply contribute to the appreciation of real estate prices, which is positive for investors. Thus, if the price increases are greater than the rate of inflation, the relative return remains mostly positive.
Invest in commercial real estate
The major pitfalls that arise when considering an investment in CRE are the size of the ticket and the lack of information on this asset class. What to look for, where to invest and which potential markets to watch?
When it comes to your inflation protection strategy, there are three ways you can start investing in commercial real estate:
The main benefit offered by fractional ownership is to reduce the size of the investment ticket, paving the way for retail investors to participate in CRE assets. Fractional ownership allows for portfolio diversification and you can freely choose the asset you want to invest in.
Real estate investment trusts or REITs are companies that are involved in the purchase, management or financing of real estate. While allowing for diversification, they also remove the hassle of being bothered by the myriad formalities and legalities involved in buying real estate. Here, just like a mutual fund, you can choose the REIT, but not the individual assets in which it is invested.
Buy CRE directly
Finally, you can opt for direct ownership or co-ownership of a commercial building. Here however, you will need to have a thorough knowledge of the market in which you choose to invest and also take care of all the formalities, legalities and charges of operating the property. This is a better option for those who have known a market for a long time, have sufficient funds to invest, and are not looking for a quick and convenient exit route.
Although the reasons are sufficiently convincing, how to start investing in CRE? Understanding the market is an important aspect, where you need to take into account demand and supply, projections of how the market will work, and asset due diligence is also required.
To make the investment experience with CRE better and hassle-free, you can either research and invest in CRE directly if you have the time, resources and expertise, invest through REITs, or choose the route of fractional ownership which decreases the burden of the ticket size required to invest in commercial real estate, while also taking care of the legalities, formalities and due diligence required to invest in CRE.