When higher inflation took hold in late 2021, investors sought different strategies to balance portfolios and maintain returns. Equities and bonds raised question marks. But commercial real estate was, and continues to be, described as inflation-resistant.
In theory, commercial real estate checks all of the “inflation-averse” boxes. It generally isn’t correlated with market movements. Where inflation goes, so do property values. And finally, owners and landlords can match price increases (and cover operating costs) by re-setting rents.
But the one box that isn’t checked in the “inflation-averse commercial real estate” discussion is that the category is huge. It has many different options. Some might perform quite well during inflationary times. Others, not so much.
Single Category, Different Holdings
NAIOP defines “commercial real estate” as “any property owned to produce income.” This includes:
- Office
- Industrial
- Retail
- Mixed-Use
- Medical office
- Entertainment
- Education
- Vacant land planned for lease or development
The above excludes residential real estate. But multifamily properties with more than five units are generally acquired and held as investments. Other residential subsectors – single-family rentals (SFR) and single-family build-to-rent (BTR) – can also be considered “property owned to produce income” under the NAIOP umbrella.
Then there is the hospitality sector, which includes hotels, motels, resorts, travel centers and amusement parks. Self-storage, senior housing, student housing – all of these can also be properties used to produce income.
Not only are CRE products different. So are the lengths of their leases. Hotels and resorts can re-set their rates literally overnight – this is where the term “average daily rate” comes from. Self-storage leases can re-set monthly, while multifamily, SFR and BTR rents re-set on an annual basis.
This isn’t the case with office, industrial and retail. Typical lease terms on these assets are three to five years. Medical office leases can last 10 years or more. Then there are net lease properties, with leases that span decades.
While most commercial real estate leases contain automatic rent increase, those increases might not support higher inflation boosts.
Additionally, commercial real estate performs differently, based on geography. At Revere Capital, our focus is on secondary and tertiary markets, where there tends to be less competition and in some cases, lower operating costs. These markets also can be less subject to inflation volatility.
We also issue lower middle-market senior private debt to opportunistic and value-add assets. As an example, rather than issuing huge permanent financing for a brand-new multifamily complex in a high-end Austin, TX submarket, we provided a smaller short-term loan for a 41-unit older property in an up-and-coming neighborhood in the city. The loan will help refurbish the property, which is 90% occupied. This can help with rent re-sets and a higher cash flow which, in turn, could be ideal in matching inflation.
Adding Demand to the Equation
Not all commercial real estate is in lock-step with its lifecycle of recovery, expansion, hyper supply and recession. One asset type might be in the recovery stage, marked by stagnant rents and lack of construction. Another might , the hyper-supply phase means a lot of supply and higher rents. Depending on the lifecycle phase and product demand, commercial real estate might not be the ideal inflation-averse solution.
Here’s another example. Industrial product is currently in the hyper-supply phase of the real estate life cycle. Demand for warehouses and logistic center space is huge. This means more is being built. Also increasing? Construction, materials and labor costs.
As long as supply remains scarce, industrial tenants will continue happily paying higher rents. But this changes when hyper-supply tips over into recession and its accompanying higher completions and higher vacancies. Higher vacancies lead to lower property values. In the recessionary phase, rents can’t be raised to offset inflation costs, either.
While we issue financing on all product types – our strategy is geographic, rather than asset-specific – we’re highly interested in retail properties. Many of our loans are secured by long-term ground leases on the properties, and these properties contain nationally known, credit-worthy tenants.
Here’s why we like it. Retail is just coming into the recovery cycle, which means it’s coming up from rock bottom. Little new construction is in play, while vacancy is in decline. These factors can justify rental increases, especially as demand for retail space continues.
So, It Depends
There are a couple of takeaways from all of this.
First, commercial real estate can be an effective investment strategy. And second, not all commercial real estate is automatically inflation-resistant or inflation-averse.
Such broad-based assumptions ignore the huge variety within this investment category. Understanding the differences in asset type, location and demand is essential when it comes to using commercial real estate as a tool during inflationary times.
For information about our bridge financing products and focus on niche income-producing opportunities, visit us at reverecapital.com.