If you want to know how inflation impacts real estate, this guide will teach you the key types of inflation, causes of inflation, and how to hedge inflation.
If you own commercial real estate, you may be wondering how inflation impacts real estate.
Commercial real estate is one of the best asset classes to hedge against inflation. In periods of high inflation, commercial real estate provides both stable, predictable cash flow and the ability to increase rent. Over the past 45 years, commercial real estate has outperformed inflation nearly 90% of the time .
Over the past several years, inflation has soared due to the Covid pandemic, supply chain constraints, high commodity prices and global conflict. Every real estate owner and investor should understand inflation, interest rates and pricing to make more informed decisions about commercial real estate ownership.
In this article, we will discuss how inflation impacts real estate, including:
Inflation is the increase in the price of goods throughout the economy, which hurts the purchasing power of consumers and businesses. Purchasing power refers to how many goods an services a buyer can purchase. When the price of goods and services increases, purchasing power decreases.
For example, a slice of pizza cost $0.15 in 1950. Today, a slice of pizza can cost $3.00. Over time, the purchasing power of a single dollar has declined, which means consumers can buy less pizza with the same amount of money. When prices increase across the economy (and not only for a single product), inflation is typically the cause.
Normal inflation is considered 2%. However, during the 1970s, inflation soared higher than 10%.
How is inflation measured?
The U.S. Bureau of Labor Statistics publishes the Consumer Price Index (CPI), which measures the monthly change in prices that consumers pay out of pocket for 80,000 goods such as food, fuel and clothing and services such as healthcare, college, preschool and daycare. The Federal Reserve uses CPI, which captures what households are buying, as the most reliable indicator of inflation.
The Personal Consumption Expenditures Price Index (PCE) tracks all goods and services that consumers buy, not only out of pocket purchases. Therefore, while the CPI price index tracks what consumers are purchasing, the PCE price index follows what businesses are selling.
Inflation affects both demand and supply. When fewer consumers can afford to purchase real estate, for example, rental demand increases. With heightened demand, a commercial real estate owner could increase rent to generate more cash flow. Similarly, higher prices for materials and labor, along with higher interest rates, could make it more expensive for real estate developers t build fewer properties. As a result, overall supply decreases, while the value of existing properties increases.
There are two primary types of inflation: demand-pull inflation and cost-push inflation.
Demand-pull inflation: Demand-pull inflation happens when the demand for goods and services exceeds supply. An increase in money supply and available credit can increase demand for good and services. However, if there isn’t enough production capacity to meet demand, prices will increase.
Cost-push inflation: Cost-push inflation occurs when the input cost of goods and services increases the total cost of goods and services. For example, if construction costs or commodity costs are higher, a company may pass on the cost of those goods and services to the consumer. Companies offset the cost of inflation by charging higher prices.
There are several causes of inflation, which can result in higher prices for consumers and businesses.
Printing Money: When a central bank such as the Federal Reserve increases the money supply – such as through economic stimulus spending – the value of money declines.
Supply Chain Disruption: A disruption in the supply chain could increase inflation. When supply is limited, demand increases and therefore prices can increase too. A labor strike or natural disaster are two examples that can cause a supply chain disruption (supply shock).
Lower interest rates: If borrowing costs are low and there is ample supply of credit, consumers can fuel a stock market rally (and make stocks more expensive) or outbid each other for a home (which increase home prices). This is called a demand shock.
Periods of high inflation can provide strong tailwinds for commercial real estate investors. An inflationary macroeconomic environment can increase cap rates and real estate prices, hel maximize net operating income, and raise property values.
There are several ways in which inflation affects real estate:
1. Income-producing property. Real estate is an income-producing asset. When investors purchase commercial real estate, they seek properties that will generate a yield above the rate of inflation.
2. Higher rent. Landlords can increase rent during period of inflation. Why? Rent represents revenue, and revenue is used to pay for operating expenses, the mortgage, property taxes and insurance. If any or all of these expenses are higher, landlords can justify increasing rent to cover their costs.
3. Increased prices. When a central bank prints more money, the value of existing homes increases. With more money and limited supply, each individual property becomes more valuable.
4. Higher construction costs. When inflation is high, construction costs typically become more expensive. This includes materials such as lumber, electrical wiring, insulation, sheetrock, plumbing and appliances. Homebuilders and investors typically pass on higher construction costs to real estate buyers.
Investors can use real estate as an inflation hedge. Why? When there is high inflation, real estate prices rise. Real estate investors can use real estate to hedge inflation in several ways, including:
Pass on costs to tenants: When construction costs are higher, for example, real estate owners can pass on higher costs to tenants or other real estate investors.
Raise rents: Multifamily investors can increase rents to cover costs.
Increase real estate prices: Real estate has intrinsic value because supply is limited in certain geographies such as urban centers. Investors can benefit from increased assest values when there is limited supply.
Real estate is a hard asset: Real estate can produce recurring income over time, which can increase its value.