How Inflation and Rising Interest Rates Impact Commercial Real Estate

Guy: Commercial real estate is an interesting asset class with unique characteristics, particularly in today’s high inflation environment with growth now beginning to slow due to sharply rising interest rates. I am glad that you can help me make sense of the opposing crosscurrents. On the one hand commercial real estate investments are viewed as an inflation hedge as values typically rise at the rate of inflation rise. On the other hand, values are affected by changes in cap rates, supply and demand, and inputs such as commodities, labor costs, and financing availability. How does it all shake out?

William: As you inferred, there are many variables that can influence commercial real estate valuations, and it’s worth considering each of them separately. I also slightly cringe when referencing the commercial real estate market as a whole, as this combines sectors with strong tailwinds like warehouses against sectors facing headwinds like office. That said, I don’t want to dodge your question so will say we are expecting real estate prices as measured by NCREIF to be up about 7% in 2022, and around 4% in 2023.¹

Guy: Ha ha, thanks for that, but perhaps we should also go through the components. Let’s start with inflation. Is commercial real estate really a good inflation hedge?

William: We believe that it is. Our research, using NCREIF data, suggests that from 1978-2021 the unlevered total rate of return from real estate is historically close to the cap rate plus the inflation rate. For investors who think high inflation will last through 2023 or 2024, we think an especially strong case could be made for real estate investments today, as values generally expand with inflation.

Guy: Let’s start with the premise of returns equaling the cap rate plus inflation because that is where it gets confusing for me. Both cap rates and inflation have risen this year which suggests that investors can expect a higher total rate of return going forward. That also makes sense because interest rates are higher, and spreads are wider, but does this mean that, like most fixed income bond, existing positions are underwater?

William: Similar to a bond, real estate valuations can be influenced by the present-value effect from interest rates. In practice, however, increases in interest rates has often corresponded with rising inflation, which puts upward pressure on real estate rents and property values. This increase in property income, or potential income, has been helping to offset the spring and summer 2022 rise in interest rates. Now that the market consensus view seems to be shifting towards inflation being “transitory”, as opposed to remaining high over the next several years, we think real estate price appreciation will be approximately flat during the remainder of the year.

Guy: As you mentioned earlier, the pandemic has caused changes to consumer behavior and to work habits. Could you provide an example?

William: The height of the pandemic certainly saw its own set of challenges when malls, offices and hotels were temporarily empty. But as we’ve emerged into the post-pandemic world, there has been noticeable shifts in the landscape.
In the office sector, the trend toward remote work has impacted some industries, and geographic locations, more than others. The geographic difference in return-to-office is particularly contributing to a dispersión in investor views of the sector, with some investors thinking the office sector is completely dead and others thinking now is one of the best buying opportunities they’ve ever seen.
Outside of office, the rise in e-commerce growth drove demand for warehouses, while remote working drove demand for housing (both single-family and apartment). Today’s post-pandemic environment is producing some of the best returns investors in these property types have ever experienced, with track records going back to the 1970s.²

Guy: Geo-political tensions, inflation and wage pressures have also shifted the real estate landscape. How else are you assessing opportunities and property types today from those factors?

William: MIM has a long history of ground-up real estate investing, and we are finding many attractive opportunities today. That said, certainty around labor and construction costs has declined, and it’s something we are putting more focus on when evaluating new projects. During the pandemic we’ve run into issues as small as not receiving a shipment of metal washers to install a roof, and as large as a plumbing company reneging on a large work contract. Thankfully, the downside from these delays has been relatively minimal from an IRR/return standpoint.
More broadly, price and behavior shifts have spilled into funding costs throughout the capital structure. Financial market conditions and the economic environment has also led to bank balance sheet constraints. Looking forward, bank appetite for real estate loans might be further impacted by Federal Reserve stress tests. That gap in capital availability could provide upside potential for non-bank mortgage investors.

Endnotes
¹ NCRIEF
² NCREIF Property Index 1977-2022

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