Is Commercial Real Estate a Hedge Against Inflation?

As inflation is currently reaching decades old highs, many investors are seeking investments to act as a hedge against inflation. Historically, commodities have been viewed as a safe way to limit exposure to inflationary risks, and in the short term, certain commodities may offer that benefit. However, with many economists predicting a recession by the end of 2023, investments in commodities pose a higher risk then in past inflationary cycles.

Many may view Residential Commercial Real Estate as the ultimate commodity. Replacement cost is high, particularly in areas of high growth and limited availability, and unlike most commodities, it can provide cash flow while leaving the principal commodity intact.

However, there are a number of variables that influence the Commercial Residential Market, independent of, or even contrary to inflation.

1)?????Rents- Aside for being a commodity, real estate is a business that is dependent on cash flow. After seeing vacancies and rent prices slide during the depths of the pandemic, the rental market has rebounded strongly with lower vacancy rates and increasing rent. While some of this may be a result of both a demographic shift and market correction, it would be reasonable to question whether similar continued performance is sustainable.

2)?????Interest Rates- Real Estate is highly dependent on leverage and financing. As the Fed begins to act to tame inflation, they have started to tighten money supply and increase interest rates leading to higher mortgage rates. Mortgage rates are likely to increase even further, considering that inflation is expected to remain high, and possibly even increase in the near future (manufacturers inflation is higher than consumer inflation).

This in itself can cause downward pressure on the Commercial Real Estate Market similar to the 2008-2009 crash. Although that crash was a result of a financial market collapse, sharply rising interest rates can have a similar impact.

How to mitigate the risk

1)?????Lock in interest rates- If you have any properties with floating interest rates, it would seem wise to lock down the interest rates for a minimum 5-year period. While that may seem painful considering that rates have already increased significantly, not doing so may prove to be a fatal error. Last time inflation reached these levels, interest rates peaked at 20%.

2)?????Sharpen your Pen- The past decade of rising real estate prices and shrinking cap rates may have provided many real estate investors and asset managers with an inflated view of their abilities. Investment and management mistakes could be glossed over in an area of ever-increasing asset values and a potential loss, could be made to look like a win. Expecting the market to be as forgiving in perpetuity would be a mistake.

3)?????Deleverage- Financing is still readily available, and it wouldn’t be prudent not to make use of it, but it may be wise not use maximum leverage on your properties. There maybe a time in the near future where financing may be more expensive, and harder to obtain, having cash reserves will allow you to wade through that period. Contrarian Opinion – Leverage your properties to the max. This will make it unappealing for the lenders to take the properties back if they run into trouble (worked for some investors during the last financial market collapse),