Inflation can be summarised as the decline of the purchasing power of a currency. In other words, it can also mean that the average price of a collection of goods and services in an economy increases in prices over time.
Since the same amount of currency effectively buys lesser goods and/or services, investments that are meant to aid in the growth of wealth are defeated in their primary purpose. That makes it all the more important to have investments that are well insulated from inflation. Commercial real estate (CRE), as an asset type, is pretty insulated from the ups and downs of the market but does it guard an investor against the deadly blows of inflation?
Inflation Vs Commercial Real Estate Trends
To understand why commercial real estate is such a resilient asset, it is imperative to know the grounding basics of this investment. Any commercial property, be it as small as a two-floor shopping center, or as large as an industrial warehouse, has its lease terms as its main saving grace. While allowing tenants to rest assured of a long-term commitment to conduct their operations, the lease agreement also allows investors to also be convinced that a long-term investment in this is not going to go awry.
Since inflation is a time-sensitive phenomenon, long-term investments are especially important. Periods of inflation have been a dime a dozen in the economy of India, but the worst cases in history have undoubtedly been in 1991 and 2008 when the inflation rate climbed to double-digit figures. Now, if the commercial property prices can be observed during the same period, while there is an initial dip, there is also a rather quick recovery.
Even during the uncertain times of the pandemic scenario of 2020, the commercial real estate market was among the few investments that remained rather insulated from the volatility of the market and started on a recovery path much sooner. These quick recovery times for this asset class are the major reason why investors make a beeline for CRE assets.
High inflation should be on the watchlist of any prudent investor because it can seriously undervalue any investment, as well as cause a dent in future cash flow. That is why investments should be such that they achieve higher returns than the going or expected rate of inflation. Let us try and understand that through an example.
From a very simplistic view, let us assume that the current inflation rate is around 5%. This would mean that investments in any asset that offer returns below 5% are actually making a loss in their purchasing power each year, relative to inflation. That would include even the safest and most basic of investments – fixed deposits. Even other safe investments like money markets and debt can also suffer from this loss. The only hope is that in the long term, the inflation rate might stabilize and the investments will start providing positive returns.
Despite that, in the long run, if the investment is left as is, the capital of the investor is able to purchase less because the cost of goods and services has increased at a faster rate than the returns provided by their investments.
To ensure such a scenario does not happen, assets need to have a higher rate of return than the current or future inflation rates, at least to the point where the returns generated are not negative. Inflation rates will mostly keep going up – the reasons for that are various and complex.
The only question remains is if a slight blip in the inflation rate is just temporary or marks the beginning of a more extended uptick in prices. Regardless of that, it is important that investors prepare to adjust their investment strategy to hedge against inflation.
Commercial Real Estate Protecting Against Inflation
There are three major ways in which CRE can protect investors from inflation. Let us look at each of those individually.
Increasing rental income during inflation
Rising inflation contributes to rising prices. That is a given fact. Rising prices also include rising rents for commercial properties. Property rental rates increasing while operating expenses stay relatively stable contribute towards positive property values.
Now, this can cause an increase in net operating income, which will appreciate property values further. As long as this value is more than the inflation rate, the investor’s investment will not be hampered if they are holding CRE.
The Lease factor
Lease agreements for commercial properties are structured in a way that increases the rents at regular intervals throughout the lease term. An agreement, for example, could have a clause that calls for an increase in the rent at the rate of 2% to 3% annually.
Based on the property and the demand and supply of the market, the clause for different assets will be different. As long as these regular increases outpace the inflation rate, the relative return will stay positive.
It is a no-brainer that space will always keep decreasing. As more houses, apartments, buildings are created to increase the supply of real estate, it conversely also creates scarcity of space. Companies will keep growing and more companies will keep opening, the requirement for commercial real estate will keep on increasing.
In dense real estate markets and commercial centers, high demand and limited supply contribute to the appreciation of prices for real estate, which is positive for investors. So, if the price increases are more than the inflation rate, the relative return stays mostly positive.
Investing in Commercial Real Estate
The major hiccups that arise when considering an investment in CRE are the ticket size and the dearth of information regarding this asset class. What to look for, where to invest and which potential markets to watch out for?
Towards your inflation protection strategy, there are three ways in which you can get started on investing in commercial real estate:
The primary advantage that fractional ownership offers is to reduce the ticket size of the investment, opening up the way for retail investors to participate in CRE assets. Fractional ownership allows for diversification of the portfolio and you can freely choose the asset that you want to invest in.
Real Estate Investment Trusts or REITs are companies that deal in the purchase, management or financing of real estate. While allowing for diversification, they also remove the hassle of being bothered with the umpteen formalities and legalities involved in purchasing real estate. Here, much like a mutual fund, you can choose the REIT, but not the individual assets it is invested in.
Buying CRE directly
Last but not the least, you can opt to own or co-own a commercial real estate directly. Here though, you will need to have an in-depth knowledge of the market you are choosing to invest in and also take care of all the formalities, legalities, and operational charges of the property. This is a better option for those who have known a market for long, have ample funds to invest, and are not looking for a quick, convenient exit route.
While the reasons are compelling enough, how do you get started with investing in CRE? Understanding the market is an important aspect, where you have to factor in the demand and supply, the projections of how the market will perform, and due diligence of the assets is also necessary.
To make the experience of investing with CRE better and hassle-free, you could either research and invest in CRE directly if you have the time, resources, and expertise, invest through REITs, or choose the path of fractional ownership that decrease the load of the ticket size required for investing in commercial real estate, while also taking care of the legalities, formalities, and due diligence involved in investing in CRE.