Inflation May Be More Supportive of Tight Cap Rates

The commercial real estate sector is “moderately well-positioned” to face prolonged inflation, according to one industry watcher, thanks to what he calls its “demonstrated ability to protect (and expand) profit margins in inflationary periods.”

“As an asset class, CRE has demonstrated its ability to protect margins in inflationary environments – and the capital markets have rewarded it handsomely with higher multiples,” says Omar Eltorai, director research at Altus Group. “While the prospects of persistent inflation may appear to benefit the asset class, continued above-trend inflation would come with continued aggressive tightening and increased risk of economic slowdown. All together – high inflation, rising rates, slowing economy – these factors would most likely pose more headwinds to property-level performance than tailwinds.”

Price discovery and investment activity will likely decrease amid higher costs and tighter credit availability, Eltorai says, but he notes that lease structures that allow owners/operators to capture the upside of inflation, as well continued strong demand for commercial assets will help keep CRE operating performance steady even as inflation rises.

“CRE’s negative expense ratio betas (to median CPI) and positive jaws ratios demonstrate how the asset class has been able to reduce expense ratios and capture more of inflation’s upside over the last decade,” he says. “While the cap rate compression is more strongly correlated with yields, cap rates are negatively correlated with median CPI and the recent trends in compression suggest that inflationary environments may be more supportive of tight cap rates than lower inflationary environments.”

But in a recent analysis, LaSalle said CRE’s status as an inflation hedge is being tested: “It would be reckless to conclude that real estate will emerge unscathed from capital market chaos or a slowdown in national economies,” the firm wrote, noting that falling stock and bond indices will likely lead to less liquidity for all forms of private equity, including real estate. And Paul Fiorilla, Director of Research at Yardi Matrix, wrote last month that the second half of 2022 will be challenging given how rapidly conditions are changing as volatility in the 10-year Treasury yield is likely to persist and that “every piece of news is a mixed blessing.”

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