Commercial real estate should be a part of any well diversified investment portfolio, but particularly during inflationary periods. Here are four reasons why commercial real estate is an excellent hedge against inflation:
- Most commercial leases include annual rental escalations. These escalations can be a set amount or can explicitly be tied to inflation indexes such as the Consumer Price Index (CPI).
- Even without annual rental increases, rental rates are subject to adjustment/renegotiation at the expiration of the lease term. In most cases, rental rates will have increased to meet inflation.
- Expenses to operate the property (CAM, taxes, insurance, etc.) are generally passed along to tenants. Therefore, owners are not directly affected by the inflationary increases in these costs.
- Higher construction costs resulting from inflation reduce commercial development allowing demand to catch up to supply thus leading to an increase in market rents.
The ability of commercial rents to keep pace with inflation coupled with protections against increases in expenses associated with ownership allow net operating income (NOI) to increase in an inflationary environment. As new development stagnates and the market moves closer to equilibrium, there is also downward pressure on acquisition cap rates which further increases property values.
Gross Operating Income – Expenses = Net Operating Income
Value = NOI/acquisition cap rate