Has Commercial Real Estate Lost Its Hedge?
We celebrated a milestone birthday here at MCRE recently, our Marketing Manager turned 40 in March. Interestingly enough, a month before she was born—February 1982—was the last time the U.S. saw inflation as high as we did in January 2022. Literally, an entire lifetime, at least for our marketing manager!
The four-decade high that inflation hit in January was an incredible 7.5%—well above December 2021’s 7% and 2019’s 1.8%. Of course, you’ve no doubt noticed the effects of this accelerated inflation already from grocery prices (up 7.4%), to energy costs (up 27%), to gas—where waiting even a day to fill up can sometimes mean a $0.10/litre increase.
Commercial real estate investors generally don’t mind inflation as their investment is seen as a secure hedge against rising prices. However, the unique conditions leading to this inflationary (including the first global pandemic in over 100 years) surge may make investors question whether or not commercial real estate has lost its ‘hedge’.
Commercial Real Estate as Inflation Hedge
There’s no doubt that there were winners and losers in commercial real estate during the pandemic. The obvious loser was office space, whose future is still undecided as employers and employees grapple with how post-pandemic office work will play out.
However, the winners appear to be multifamily and industrial [LINK TO OLDER BLOG], both of which have soared in value since the onset of Covid-19. In 2021, real estate stocks gained more than 43% (about 15 percentage points more than the S&P 500) and a record $809 billion in commercial real estate sales were transacted.
Problems with Office Space
Besides the uncertainty of its future, there are other issues with office space that may prove problematic for investors in an era of rising costs.
The most important consideration for investors will be the tenancy of office buildings and whether those tenants have long-term leases. It’s not uncommon for office landlords to sign 10-year or even 20-year leases with their tenants, as rapidly rising costs weren’t on anybody’s radar until recently. Long-term lease agreements will be a real issue if inflation continues to increase, as costs will eventually eclipse rents and leave landlords in a deficit position.
Problems with Commercial Hedges
“If [interest] rates rise just because of inflation, real estate is still viewed as a good bet…[if rates go up because of forces other than inflation] that is very uncomfortable for real estate values.” Cedrik Lachance, head of research for Green Street, a real estate analytics firm
Historically, real estate investment trusts have fared well in conditions similar to those we are seeing today, but that inflation was driven primarily by inflation. Banks and bond investors can increase interest rates given a poor economic outlook and a real risk of not being able to recoup costs. Analysts predict that the 10-year Treasury rate would need to rise above 3% before investors may not find the premium offered by real estate as attractive as the security of fixed-income investments. If this should happen, commercial real estate may not be able to provide the inflationary hedge it has in the past.
Commercial Real Estate: Sure Bet or Gamble?
When it comes to investing, of course, there are no ‘sure bets’, only varying levels of risk and return, but whether or not commercial real estate will deliver long-term returns commensurate with its risk remains to be seen.
Some commercial real estate investors are diving in, assuming they will be able to raise rents in tandem with cost increases, while others are on the sidelines taking a wait-and-see approach.
Are you considering adding commercial real estate to your portfolio? Are you concerned about the profitability of current investments you have? Don’t make decisions in the dark! Contact the professionals at MCRE to evaluate your particular situation and provide you with custom advice designed to maximize the performance of your investment or portfolio. We’re waiting to help you succeed, call us today!