INTRODUCTION
Inflation is one of the most critical drivers of commercial real estate (CRE) performance. When inflation is low, CRE values tend to rise as investors seek higher-yielding investments. However, when inflation is high, CRE values tend to fall as investors become concerned about the potential for eroding returns. The following analysis will provide an overview of how inflation impacts CRE values.
OVERVIEW
Inflation is defined as a sustained increase in the general price level of goods and services in an economy. In the United States, inflation has averaged around 3% per year over the last century. There have been higher and lower inflation periods, but the long-term average has been relatively stable.
The impact of inflation on CRE values can be broken down into two main effects: direct and indirect effects. The direct impact of inflation on CRE values is fairly straightforward. As prices rise, the value of CRE assets also rises. Commercial real estate is a physical asset that becomes more valuable as prices increase. For example, if an office building was purchased for $1 million last year and the price of office buildings has risen by 5% this year due to inflation, then that same building would be worth $1.05 million today.
The indirect effect of inflation on CRE values is a bit more complicated. To understand this effect, it’s first necessary to know how CRE leases work. Most commercial leases are structured with periodic rent increases tied to some measure of inflation (e.g., CPI). This means that as prices increase, so too does rent. And since rent is the primary source of income for most CRE owners, higher rents lead to higher property values.
To illustrate this point, let’s assume that an office building was purchased for $1 million last year, and it’s expected to generate $100,000 in annual rent. If prices rise by 5% this year and rents also increase by 5%, the building would be worth $1.05 million today (i.e., $100,000 / 0.05 = $1 million x 1.05 = $1.05 million).
This is because higher rents increase the cash flow that an investor can expect from a property. Cash flow is one of the most critical value drivers for income-producing assets like commercial real estate.
IN SUMMARY
Inflation is one of the most important drivers of commercial real estate performance. When inflation is low, CRE values tend to rise as investors seek higher-yielding investments. However, when inflation is high, CRE values tend to fall as investors become concerned about the potential for eroding returns. The impact of inflation on CRE values can be broken down into two main effects: the direct and indirect effects. The direct effect of inflation on CRE values is fairly straightforward; as prices rise, so too does the value of CRE assets . The indirect effect of inflation on CRE values occurs because higher prices lead to higher rents which, in turn, lead to higher property values. Understanding how these two effects work is essential for making informed investment decisions in today’s market.