It is commonly talked about that real estate offers a good hedge against inflation. Typically, the value of real estate will align with, if not slightly edge out, inflation rates.
But what are the actual drivers, specifically in commercial real estate, that make this true? And are these drivers equivalent among the specific types of real estate: multifamily, retail, industrial, and hospitality?
To better understand the true nature of any inflation hedge, we need to look to where the returns of real estate are generated:
- Income/cash flow
- Sale value/cap rate
The sale value will have a direct correlation to the net operating income, but outside forces — meaning market cap rates — will have a direct impact as well.
Inflation will typically have an upward pressure on rents. More rent means more income. More income means higher sale value. Therefore, commercial real estate is a good hedge against inflation.
But if you unpack that between asset types, can an operator truly realize higher rents? Most office, retail, and industrial leases are five years or longer, and oftentimes have predefined renewal rates for even longer terms. When you get into anchor tenants, it is not uncommon to have 20-year leases. These types of leases do provide surety of income, particularly from credit tenants, but in a high inflationary environment, the owner cannot adjust rents mid-lease term, so, therefore, they cannot realize the upward pressure on rents. Leases on vacant units can reflect current market conditions, but this could have a minimal impact on NOI, depending on the size of the unit.
Now, when compared to multifamily and hotel assets, these have much shorter leases. The typical residential lease is 12 months, and a hotel “lease” is often one day to a week. Due to the shorter length of the lease, the apartment or hotel owner has more frequent opportunities to adjust their rental rates, allowing these assets to better realize higher rents due to inflation.
Regardless of asset type and the ability to capture current income, commercial real estate carries the inherent value of future cash flow. So, a property in an area with historical trends of strong rent growth will still sell for more than comparable assets in areas with lower rent growth expectations.
Sale Value/Cap Rate
The sale value of commercial real estate is calculated as net operating income (NOI) divided by a capitalization rate, or cap rate. The cap rate, which is represented as a percent, can create very large swings in value.
For example, if an asset generates $5 million of NOI and the market cap rate is 10%, that creates a $50 million value. If the market cap rate drops to 8%, the value is $62.5 million. Many core assets, particularly in the favorable asset classes of multifamily and industrial, trade in the 3%–5% range. The same $5 million NOI property trading at a 4% cap rate is valued at $125 million. Drop the cap rate to 3.8% — so, only a 0.2% change in cap rate — and you have a property worth $131.6 million, or $6.6 million more than at a 4% cap rate.
So how does inflation affect cap rates, and ultimately sale values?
Historically, cap rates will move with interest rates. As interest rates go up to stave off inflation, the cost of capital for borrowers goes up, and therefore the returns needed from their investments need to increase as well. And an increased cap rate lowers the overall value.
The balance here is that oftentimes, interest rate increases are a reaction to inflation, not a leading indicator. Therefore, there is the ability for rents to rise, and for NOI to rise at a fast rate, to counterbalance the rise in cap rates.
The Wildcard Factor
While income and cap rates are fairly easy to measure, demand is not. Historically, investor sentiment moves towards hard assets in markets showing high inflation. This increase in demand helps keep values high for those hard assets: real estate, gold, oil, and even collectibles.
So, while capital market effects can often imply a decreased value, the natural demand that comes from inflation helps increase the demand and often balances out rises to cap rate.
Overall, real estate — specifically commercial real estate — has proven to be a strong investment option. In good economies and bad, real estate continues to show its resilience through its ability to create current cash flow and retain long-term values.
About the Author:
Evan is the Investor Relations Manager for Ashcroft Capital. As such, he spends his days working with investors to better understand their investment goals and backgrounds. With over 13 years in real estate, he has seen all sides of real estate from acquisitions to capital raising on the equity and debt side, to operations, and actively invests himself. Please feel free to connect with Evan on Linkedin.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.