Marc DeLuca is CEO of KBFone of the largest investors of prime commercial real estate in the nation.
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In its ongoing effort to combat ongoing inflation, the Federal Reserve increased the effective federal fund rate (EFFR) for the fifth time in September 2022. The combination of inflation and interest rate hikes has led to ongoing questions and concerns about the impact on commercial real estate, sales volumes and caps.
I’ve noticed some experts point out that commercial real estate (CRE) can be a solid hedge against inflation, providing an alternative investment vehicle during unpredictable market conditions. Others seem to note that the rise in the cost of capital and real estate prices is sidelining potential investors. And both sides tend to use Great Inflation of the 1970s on which to base some of their conclusions.
But to state unequivocally that commercial real estate is an ideal hedge against inflation is a very general statement that does not take into account certain factors. Namely, the CRE product type, location and asset class along with the type of inflation.
Commercial real estate: a historical context
Let’s go back to the 1970s for a moment. It is important to keep in mind that commercial real estate as an alternative investment did not really exist during the Great Inflation. Still, 1970s investors who could add real estate to their portfolios benefited from this. Supported by modern portfolio theory (MPT), with an emphasis on risk diversification and diversification, commercial real estate assets were ideal for diversification and as a hedge against inflation. These investments provided balance, using solid fundamentals and non-correlation with the general markets.
Commercial real estate today can offer the same portfolio characteristics. I also find that investors have more methods of acquiring CRE assets, such as through public (and private) REITs, private equity and mutual funds, and CMBS offerings. The lending industry has also expanded, offering a variety of debt options to commercial real estate investors.
In short, I believe that the current CRE industry is institutionalized and capable of providing a variety of investment opportunities, but relies heavily on specific real estate product types, asset classes and location.
The very broad definition of CRE
The National Association for Industrial and Office Parks (NAIOP) defines commercial real estate as “any real estate owned for income generation, including office, industrial, retail, mixed-use, medical offices, entertainment and educational facilities.” While NAIOP’s definition does not include housing, others point out that: any income generating home of a certain size (including single-family rental housing and multi-family housing) is also used for investment purposes by investors.
The advantage is that CRE is a very broad investment class. So I believe that making the general statement that commercial real estate is a hedge against inflation ignores the fact that hedging capabilities depend on where each type of real estate product is positioned in the market. real estate life cycle.
Also important in the CRE/inflation discussion is the geographic location and class of the property. The latter focuses on the age, location and function of the property. For example, my company’s investment focus is on Class A, best-in-market commercial real estate in high-growth markets, which today mainly includes office buildings, industrial assets and multi-family homes. I notice the office sector is changing, driven by remote working and hybrid/virtual workplaces. At the same time, tenants are focused on a flight to quality, meaning greater interest in newer or newly renovated, feature-rich office buildings in regions with a growing population.
In the meantime, demand for multi-family continues to riseas potential home buyers remain tenants rather than face the mortgage interest rate and the sale price of the home increases. In addition, residents are increasingly buying products online, increasing demand for distribution centers and warehouses.
The same factors that drive inflation mean that certain real estate can provide a hedge against that same inflation. But that does not apply to the entire sector. For example, an increase in online spending can have a negative effect on certain parts of the retail sector and the associated real estate. Ongoing inflation, combined with rising labor costs, continues to affect the performance of hotels and motels as well.
CRE investments in the current inflation period
Personally, my grandfather fueled my interest in and exposure to economic policy. My grandfather worked in the Department of Economic Stabilization of the Office of Emergency Preparedness under President Richard M. Nixon. And thanks to him, I learned that inflation is not equal, especially when it comes to investment in commercial real estate. Inflation in response to strong economic growth can be positive for CRE investors. Persistent unemployment and stagnant demand can have the opposite effect.
Currently, unemployment remains low, while consumers – for now – continue to spend, even with higher prices. The GDP fell in the first quarter of 2022—after an increase of 6.9% compared to the previous quarter. However, current projections suggest that Q3 is on the rise.
It is true that CRE investment opportunities may not be as easy to predict as they used to be due to the interest and price increases and the compression of the cap rate due to the current inflation times. Not to mention the sequel speak of an impending recession (paywall). On the other hand, I believe there is a lot of capital that continues to chase CRE deals. Strong real estate valuations, high rental rates and declining commercial and multi-family mortgage delinquencies may indicate higher investment returns.
In short, depending on property type, class and geographic location, commercial property can be ideal as a viable hedge against inflation and a strong alternative investment option in different economic environments.
Assessing asset performance and broader trends affecting how people use space, as well as proprietary risk tolerance, can help determine whether to invest in CRE at this time — and if so, in which product types and markets. Portfolio diversification is another important practice to remember. By regularly checking your portfolio and balancing it by investing in different sectors, you increase the chance of better results. Analyzing the performance of different CRE classes can help guide the decision to invest in one or more sectors, particularly by looking at market trends to anticipate areas that could deliver higher returns over time.
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