Posted on November 4, 2022
How Inflation Affects the Value of Commercial Real Estate
In June 2022, the national inflation rate inched past 9 percent. That’s more than seven points above the Federal Reserve’s (Fed’s) target rate. Although prices for some consumer products seem to have plateaued or dropped, Kiplinger forecasts that high inflation will carry over into 2023. Kiplinger also predicts that an economic slowdown will lower the inflation rate to 3.5 percent by the end of next year.
Whatever happens over the next several months, inflation has already sent shockwaves through the commercial real estate (CRE) landscape. For CRE stakeholders, inflation isn’t a matter of “if.” It’s one of “for how long, and to what extent.”
For this article, we asked our appraisal experts to discuss how the CRE market tends to respond to inflationary conditions and place today’s record-breaking inflation in a historical context. We also asked them to answer the most pressing questions they’ve received from brokers, lenders, landlords, and investors about inflation and commercial property values. Keep reading to access their unique insights.
Inflation and Commercial Real Estate: The Conventional Wisdom
Investors have traditionally considered CRE a solid hedge against inflation. Rents are sensitive to inflation, meaning income from short-term leases almost always rises as prices of other goods and services do. Many long-term rentals often include escalator clauses linked to the consumer price index (CPI). Consequently, CRE is usually capable of producing a reliable income stream whose value is not eroded by price spikes.
That said, markets are complex. Inflation’s effect on real property values and operating income will vary depending on which economic forces are driving it. For example, inflation caused by economic growth translates into rising rents and low vacancy rates, which is good for almost all property types. On the other hand, steep increases in the cost of raw goods, energy, or wages can reduce a company’s production capacity. As employers cut jobs to control their expenses, the economy can slip into recession. Under these conditions, property owners can expect increased vacancies, making it difficult to pass their rising costs on to tenants.
Although property values tend to increase in proportion to inflation, these are extraordinary times. Historical data from The Great Inflation (1965-1982) may not provide much guidance. We are dealing with a different economy, different monetary policies, and the lasting effects of a once-in-a-century pandemic.
On a more positive note, if a recession does occur due to inflation, a solid foundation already exists for the economy’s eventual recovery. The consensus among most economists is that 2022 is fundamentally unlike 2009, when a broken banking system, excessive risk-taking, and high levels of personal debt precipitated The Great Recession.
Inflation and CRE: Frequently Asked Questions (FAQ)
How Can Inflation Impact CRE Supply and Demand?
Inflation can reduce future CRE inventory. The main culprits here are rising construction costs, such as labor and building materials like concrete, and more expensive financing. (As we’ll see, higher interest rates are among the Fed’s favorite inflation-fighting tools.) Developers may even halt work on new projects entirely, buying time to determine whether they’re still financially viable.
Of course, any slowdown in new construction places a premium on existing properties. This is certainly the case in the multi-family sector right now. Rents have been keeping pace with the CPI, and the national occupancy rate is hovering around 96 percent. In fact, because inflation is driving up both home prices and mortgage rates, it’s simultaneously cooling the housing market and stoking demand for rental units.
How Do Policies Intended to Control Inflation Affect CRE Values?
In March of this year, the Fed began introducing a series of interest rate hikes that have since pushed the short-term lending rate up by 2 percent. Indications are that more increases are coming. How borrowers respond remains to be determined, but signs point to at least a modest drop in transaction volumes, and more so where pandemic-distressed asset classes, such as office and retail, are concerned.
Interest rates can affect any given commercial property’s value, but supply and demand, income potential, and operating costs are just as meaningful. Monetary policies indirectly affect all these variables. Deals generate much of the data that CRE appraisers rely upon to form reasonable opinions of value, but experienced valuation experts know how to make use of all available sources of information when the clouds start to outnumber the market’s silver linings.
How Exactly Do Commercial Real Estate Prices Factor into Appraisals and Valuations?
Sales data from recently sold comparable properties gives commercial appraisers insight into the current market. As noted, however, comparative market analysis (CMA) is only part of a comprehensive appraisal. Appraisers also research net operating income (NOI), capitalization rates (cap rates), vacancies, property history, and depreciation, weighing these and other data points to arrive at an accurate value.
How Can Inflation Affect an Appraiser’s Ability to Perform Comparative Market Analysis?
In inflationary periods, real estate values can change rapidly as wary buyers pull back demand. Comparative market data (comps) may be outdated before an appraisal report is completed. That’s one of the reasons why LPA is committed to 100-percent on-time delivery — a commitment we can meet with our state-of-the-art technology and access to rich data. We base our analyses on the most current data and deliver those analyses so that you can act quickly on that time-sensitive information.
How Does Inflation Affect Cap Rates?
Following interest rates, cap rates generally rise as property values increase. Re-pricing rents on multi-family, self-storage, and other properties with short-term leases to keep pace with inflation can increase NOI and help compress cap rates.
Does Inflation Make One Valuation Method More Useful than Another? How Do Appraisers Adjust Their Methodology Under Inflationary Conditions?
As Mitchell Austin, Senior Managing Director at LPA Dallas, explains, the best appraisers draw on their experience and knowledge of local markets to determine the most appropriate valuation method, or combination of methods, to use. This is true no matter what the inflation rate might be. “For example, during times of inflation brought on by supply chain shortages, we tend to see some obsolescence in new construction until pricing of market transactions can catch up with rising construction costs,” he says. “Most market participants would prefer to acquire an existing property that fits their needs rather than incur the time and effort of new construction. Until construction becomes cost/time prohibitive, market transactions will remain below the cost approach.”
The best appraisers also understand that inflation can affect every asset type differently. Currently, existing industrial and multi-family properties are experiencing near-full occupancy rates and rising rents (although Q3 2022 results suggest demand may be easing off). These properties are better positioned to hold their value as the reliable stream of income they generate may make higher borrowing costs more acceptable.
That may not be the case for office properties still sitting half-empty due to the widespread adoption of remote work. Upscale amenities are becoming more desirable as businesses seek to give their people more incentives to return to their pre-pandemic work habits. When appraising this asset class, highest and best-use valuations may be more relevant than in the past.
Which Property Types Are Most At-Risk Because of Inflation?
Properties with long-term leases, such as large retail complexes or warehouses, are the most vulnerable. Built-in rent increases of 2 or 3 percent may have been safe bets at one time, but these properties will experience declining returns as the inflation rate rises beyond contracted increases.
New developments may also prove risky as materials and labor make building more costly, requiring more financing at higher interest rates.
Which Property Types Might Actually Benefit from Inflationary Conditions?
Existing properties subject to short-term leases — multi-family, mobile home parks, self-storage, hospitality — can generate reliable streams of revenue that keep up with inflation. Provided the overall economy and employment remain strong, landlords may pass increased costs on to their tenants. Also, as the cost of borrowing rises, current CRE holdings are locked into lower interest rates, giving them an advantage over new acquisitions.
To connect with any of LPA’s commercial real estate market and appraisal experts, contact any of our 8 Texas locations today.