Soaring gas prices are wreaking havoc in industries and economies everywhere and commercial real estate has not been left unscathed. As an industry with many facets, rising gas prices impact in so many ways. The cost of oil and gas was on the incline at the start of the year and then started seeing a further, steeper surge as the Ukraine-Russia war began. Rising gas prices typically lead to inflationary pressure and higher prices across an economy as businesses increase the cost of their products and services to compensate. A vicious circle ensues as labor costs then creep up with inflation. With no end in sight to the uncertainties fueling price hikes, what’s the impact on commercial real estate and what might be done to mitigate against it?
Impact of Inflation on Commercial Real Estate (CRE)
In essence, as prices increase the cost of doing business increases. In any real estate transaction, it’s more expensive for all parties to operate and this spans site selection and development, architecture, construction and carries through to building management. There are no guarantees when prices might stabilize, indeed economists are forecasting that things may get worse before they get better.
Supply chain challenges will persist through the year and food prices continue creeping upwards along with global unrest; add into this the shutdown of the entire Chinese economy and predicting the future based on historic trends is impossible in this abnormal situation of ‘unknowns’.
The federal government has been using monetary policy to try and curb inflation by way of increased interest rates and the feeling is that they are likely to hike rates by a full percentage point in the next few months. Of course, higher prices and higher interest rates mean different things depending who you are in CRE and what the asset is so there are many variables involved.
Unlike intangible investments into stocks and shares for example, which can fluctuate as economic factors affect a companies’ performance, commercial real estate has long been seen as a hedge against inflation. In normal inflationary periods, the value of your property would continue to appreciate as prices go up and so long as long-term financing is fixed at a low rate, inflation can actually yield outsized returns. Interest rates are still historically low so as prices rise, putting your money into real estate can generally be considered a safe investment.
Higher costs of construction, materials and labor along with rising interest rates make building and financing more expensive and developers may be reluctant to commit at this time. Less development means less new supply coming onto the market and this gives property owners a bigger share of the available pie plus free reign when setting rental rates and terms at a time when demand outstrips supply.
Depending on the type and conditions of a lease, inflation could present advantages and disadvantages for tenants. Short-term leases may favor landlords who can push rates up to counteract higher operational costs whereas tenants that committed to longer term, guaranteed flat-rate rentals for the entirety of the agreement will be protected from inflationary rate hikes.
What can the CRE industry do to mitigate price hikes?
Increasing costs cannot always be absorbed in real estate, in office and retail it may not be as easy to raise rates and in the hotel class, escalating labor costs are more of a challenge than in others.
For commercial real estate investors the strategy will be different depending on asset type and goals; absorbing cost increases into the business may be an option for assets with unprecedented demand such as industrial class where cost increases may be offset by unrivaled growth, it might not be the right approach for office as it gets back to some sort of ‘status-quo’ post-Covid.
It’s vital for CRE investors to use professional advisors who can advise on ways to maximize every investment. Property values and growing costs must be carefully weighed up if investors and owners are to take advantage of a unique market with the potential for multiple high yield opportunities.
Some of the things to consider carefully as we go through this transitional period are…
The boundaries for business premises have changed irreversibly. Employees will continue to work remotely or opt for hybrid work arrangements which means offices, whilst still crucial, no longer have to be centrally located. Adding to that, the mounting pressure on individuals’ cost of living, and workers will be reluctant to return to a costly commute.
During an uncertain economic period, returns will rely on sensible structuring of leases. Lease terms are a key area for all investors and property owners to get right in order to maximize investments. Faced with further interest rate hikes, it’s prudent to look at shorter-term leases with terms built-in to allow for rate increases that are at least in line with inflation.
Hold term is another crucial area to be scrutinized. If interest rates continue to rise over the next two to three years as anticipated, disposing of new property in the near future will likely not provide any hedge against inflation as the cost of borrowing to fund real estate becomes more expensive. It may be that holding on to existing property is the best strategy as resell values could stabilize in the short-term but a commercial real estate consultant experienced in the location would be best placed to advise. Refinancing an existing property could also be an option to maximize returns before borrowing becomes prohibitive.
Zoning restrictions increase in importance as inflation rises. Securing commercial space with multi-use zoning can give property owners an edge when it comes to selling. Your real estate broker will have in-depth knowledge of zoning restrictions in the area to help ensure you obtain a property that’s as desirable as possible for future buyers.
Buying smart property with sustainable certifications such as LEED is another way that investors can future-proof and attract tenants that are willing to pay a premium for the space. Although these properties may cost more upfront, the returns should be much higher plus there are an increasing number of financial incentives in place to investors in this area.
Counteracting Inflation in CRE is a Gray Area
In ordinary times it would be easy to predict any and all CRE performance as a strong hedge against inflation; unfortunately times are still far from normal and investment potential is more nuanced than it once was. Investors and existing property owners must work with an experienced real estate broker to maximize every dollar spent.
Reach out to PCG and utilize our 30 years’ of combined experience to help you navigate CRE investment during fluid economic conditions.