Inflation is here. What should you do about it?
Inflation is a perennial news item, but it has been an all-but-inescapable element of the news cycle in 2021. Jobs reports describe a job market full of job openings, supply crunches have spread alongside burgeoning demand, and the CPI report shows elevating inflation, although the rate of this increase has decreased slightly at the time this blog entry was published. Qualifiers aside, inflation is worth paying attention to, and not because it can be a foolproof conversation topic at cocktail parties and social gatherings.
Inflation is worth paying attention to because there is something you can do about it.
As a general principle, you should look to invest in assets that do not de-value with currency—assets that track or out-pace inflation. Physical assets are one place to look.
Copper is often thought of as the canary in the coal mine when it comes to inflation, and commodities like oil and gas are other possibilities, as is gold to some extent. And there’s another investment option, in which a real, physical asset has a high potential for appreciation that can continue beyond a finite inflationary period. You can invest in real estate.
Commercial Real Estate Benefits and Options
The variety of real estate sectors, classes, and strategies leave investors with an array of options. Again, you should look for real estate assets that do not de-value with the value of the dollar.
You could look into the heated market for single-family homes, but elevated materials costs could make home flipping and renovation costly. Additionally, home buyers are not driven by the same motives as investors, which could lead to some unpredictability and volatility in such a hot housing market.
Commercial real estate (CRE), which includes multifamily along with industrial, office, and retail as its main sectors, has the potential for cash flow along with appreciation, but some CRE assets are better equipped to handle an inflationary environment, and a lot of it has to do with the length of the lease. Office and retail are options, and while they do have the potential for appreciation that could outpace inflation, the long-term nature of many retail and office leases could hamper both the appreciation and cash flow of the asset. With tenants signing five or ten-year leases, the asset’s capacity to track inflation is significantly reduced.
An Inflation Nightmare with a Long-Term Lease
Here’s one simplified example of how long-term leases can hinder CRE performance: You’re the owner of an office building, and a large business signs a 5-year lease for the majority of the building. $200,000 per year—again this is a simplified example that leaves out many of the details associated with cash flow and income from the property.
When you write out the lease contract, you assume 2.3% inflation every year. The start of year one is fine, but some worrying trends begin to emerge in the spring that only worsen as the year progresses. Inflation grows from 2.5% to 6% by the end of the year (3.5% on average).
At the start of year two, your lease falls behind inflation: 102.3% to 103.5%. $204,600 to $207,000.
Year two is not good for you. Inflation peaks at 8% year-over-year in the summer of year two, but, much to your relief, it settles down to 2.5% by the end of the year (6% average for the year)1. At the start of year three, your lease is at $209,306. Inflation would have it at $219,420.
Rents are increasing in the area around your office building, but you’re in the middle of a 5-year lease. Even if inflation is a steady 2.3% going forward, because of the long-term nature of your lease, you’ll still be stuck at year-one prices. At the start of year four, your lease is at $214,120, but inflation would have it at $224,467. In year five, your lease would be $219,045 to the inflation-adjusted $229,629.
For the full five years, your lease would bring in $832,551 compared to an inflation-adjusted $856,049, a $23,498 difference. In this example, inflation erodes 2.8% of the value you expected from the lease because longer lease terms prevented you from raising rents to match inflation. This is a non-trivial amount when considering that CRE properties are also valued by the income they bring in. That lost income brings down the value of the property as prices rise higher than the terms stipulated in a long-term lease.
Tracking Inflation with Shorter Lease Terms
With shorter lease terms, like those found in self-storage, hotel, and apartment properties, rents can rise as prices rise. In many cases, due to the uneven nature of inflation-related price increases, the value and cash flow of well-positioned CRE assets can outperform inflation. Without the large drag on the bottom line, a self-storage, hotel, or multifamily investment project may also stand to benefit from the increased economic activity that is often associated with an inflationary environment, but the volatility associated with inflation conditions means that it is important to choose a stable asset.
Inflation does not raise all prices at once, which can leave investors vulnerable if they invest in riskier assets. Hotel properties can change the price of a room very quickly, and self-storage also has this price flexibility. In the right market and circumstances, these assets can serve as an effective hedge against inflation, but the hotel and self-storage markets can be less stable than multifamily, which performs well in a variety of economic conditions.
Multifamily investment is an attractive option for investors not simply because it is so well-positioned during an inflationary period. Multifamily assets have shown remarkable resilience during the economic crises associated with the Covid-19 pandemic, and investors have become increasingly drawn to the long-term stability and solid growth of this asset class.
1 – The inflation numbers here are purely hypothetical and are intended to represent the “nightmare” scenario described in the section title. Inflation rates have not reached these levels in more than 25 years.
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