Inflation is the decrease in purchasing power of currency, which manifests as higher costs for goods and services.
An annual increase in inflation that equals 2% or less is considered healthy, but greater rises can be problematic—especially when they occur without a comparable increase in wages.
Increases in inflation are frequently tracked by the Consumer Price Index (CPI) or the Producer Price Index (PPI), and since the pandemic, we’ve seen the steepest change in PPI since February of 1980.
Severe inflation impacts all facets of the economy—and in this post, you’ll learn why the commercial real estate industry is no exception.
7 Ways Inflation Is Affecting Commercial Real Estate
Here are several aspects of commercial real estate that have been impacted by inflation.
1. Construction costs are higher. The increase in costs of supplies and labor has led to more expensive construction and renovation projects. The limited availability of many resources, brought about by a disrupted supply chain, has also played a role in the climbing prices of materials like lumber.
2. Cost of funds (debt and equity) used to finance purchases are higher. As the Federal Reserve System continues to raise interest rates with the hope of lowering inflation, the cost to borrow money will continue to go up for organizations. Additionally, equity financing is more expensive because of increased risk.
3. Operational costs, like utilities and insurance, have gone up. Inflation in combination with other factors like the pandemic, world conflicts, and weather changes have all led to increased utilities and insurance costs.
4. Costs of energy, transportation, storage, and supporting services are all fluctuating. Higher gas prices have led to higher costs for energy, while transportation and material costs are also rising. Goods are rising in price faster than services because of supply chain delays.
5. Property values are increasing. While rents increase, property values tend to move lock step upwards as well, resulting in high values. These changes generally start small but can increase over time.
6. Rent payments are likely to increase. While rent rates depend on supply, demand, and the asset in question, rent generally increases in response to higher property values, driven by inflation.
7. Commercial real estate is in short supply. In times of high inflation, the availability of commercial real estate decreases faster than it can be developed—this trend is especially true for logistics properties. Rising costs of development and a slowed supply chain mean that new real estate cannot be developed quicker than it is occupied.
Why Inflation Matters to CRE Tenants and Owners
The impact of inflation goes beyond trends covered in an article. As a tenant or owner of commercial real estate, you'll notice the tangible effects of rising inflation in two places:
- Profit and loss (P&L) impact. Otherwise known as an income statement, a P&L statement reflects the costs, expenses, and total revenue incurred in a period of time. When inflation increases, so too does the rent and operating expenses tenants are expected to pay. This increase in occupancy costs weighs on profits and negatively impacts the P&L statement.
- Balance sheet. When looking at the P&L, an increase in inflation of 3% typically yields an increase in opex of 3%—representing a 1:1 cause and effect ratio. However when valuing equity, the impact of inflation is not 1:1. Most equity is valued using a multiplier and therefore, inflation’s impact on equity valuation is non-linear, perhaps it is 2:1 or 3:1 depending on the situation.
Rising inflation impacts interest rates, which in turn impacts total cost of funds, which in turn impacts cap rates, which in turn impacts how assets are valued and the amount of underlying equity that exists.
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