Commercial real estate has long been a tool to hedge inflation by storing value. But after 15 years of dovish Federal Reserve monetary policy, massive stimulus from tax cuts and then pandemic aid, and disrupted supply chains, the usual may not be the new normal. Investors seeking an inflation hedge should look carefully at CRE and exactly what areas they’re getting into.
Many in the industry are spooked. “At a macro level, it’s nervousness about systemic inflation,” Paul Getty, CEO at First Guardian Group, tells GlobeSt.com. The overall M2 money supply has “grown in excess of 20% in the last year,” he adds. “Those who lived back in the 70s are getting nervous about the same kinds of things we heard back in the 70s.”
The 70s were an unusual period. With cheap money intended by Richard Nixon to boost the economy with an eye to a presidential reelection, there were also the end of the gold standard, angst over the Vietnam War, and ultimately OPEC policies driving up energy costs.
Then again, a global pandemic is also unusual. It’s kicked off inflation that may or may not affect CRE rents, depending on the sector. That’s a central consideration on whether a given real estate investment might provide a hedging mechanism.
“First of all, the way you can protect yourself is to buy and own an apartment building,” Al Lord, founder of Lexerd Capital Management, tells GlobeSt.com. “Apartment leases come up once a year. You review at prevailing rates. The way you protect yourself even further is to lock in a long-term fixed rate mortgage. We do 10-year fixed-rate Fannie Mae loans, but you can do a 30-year HUD loan. The mortgage is the biggest cost on your statement. You’re effectively hedging against higher inflation.”
But even that has limitations. “There’s only so much you can do to offset it with rent,” Alexi Panagiotakopoulos, chief investment officer of Fundamental Income, tells GlobeSt.com. “Unless you’re a hotel that can change the rates nightly, inflation changes by the day, by the month, by the year.” If inflation rates become unstable and start to grow, that can mean being locked into a deepening pit, with an annual ladder to climb out. At that point, you may have locked in some amount of value loss.
Depending on lease increases might not work so well in new construction, given that a project will feel the impact of price hikes in materials. It also can be risky in the popular area of industrial real estate.
“There’s definitely some good things about industrial but as a real estate owner I would not want to negotiate with Amazon or Walmart or some of the large retailers because they’re brutal on their negotiations,” Lord says. A low fixed annual adjustment, conceded to get a large tenant with great credit, might turn into a continued loss of future income value over 15 or 20 years if inflation exceeds the contractual escalation.
Panagiotakopoulos suggests considering the “total return investment.” Look not just at cash inflows, given “massive compression in cap rates,” but where the value of real estate can go.
Avoid any “mob mentality,” Panagiotakopoulos says. “’I have to buy real estate.’ Just because you buy real estate doesn’t mean you’re right. It doesn’t mean your neighbor is right.”
And consider other tactics to protect against inflation. “Some of our more sophisticated developer clients have purchased future contracts to control costs on certain commodities such as lumber,” Gary Tenzer, co-founder and principal at George Smith Partners, says. “Many of our clients use hedging instruments such as interest rate collars or swaps to protect against interest rate risk.”