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What does inflation mean to commercial investors?

By Greg Bell

Inflation happens around the world — it puts a higher price on goods and services, and can greatly affect an investors' buying power. The annual inflation rate has risen to 3.5% in Q4 of 2021, a .5% change from Q3 and high above the estimated market rate of 3.2% due to skyrocketing gas prices, material shortages and global supply chain stalls, according to Trading Economics. Inflation at this rate can cause significant economic disruptions and unpredictable effects on asset prices.

But how will these changes affect commercial investing? This article will highlight signs you can look out for before adding to your portfolio with commercial real estate in commercial real estate to ensure you're making the right investment.

The cash rate

While the unemployment rate has decreased significantly and is the lowest it's been since 1974, concerns around the slow rate of wage increases to combat the increase in inflation have put pressure on the Reserve Bank to respond. Despite economic hardships in Ukraine with Russia's invasion and ongoing floods in Queensland and NSW, the national budget is confident inflation will reseed by September.

The fears are coming from previous experiences in the 1970s and 1980s when inflation spiraled out of control and the Reserve Bank was forced to intervene — halting growth altogether. Historically, however, inflation had little to no effect on commercial investment, and returns are more closely correlated with economic growth than the rate of inflation, according to Commercial Property Executive writer Paul Fiorilla, director of research at Yardi Matrix.

Inflation and commercial property

Commercial property investment has several protections against inflation to ensure steady growth for long-term leasing known as annual fixed increases. These rates are set by the Consumer Price Index (CPI) and are predetermined without inflation taken into account known as a fixed percentage.

Additionally, leases are typically set up with expense pass-through mechanisms. This means the landlord is not required to meet the additional price of the lease, but the tenant is required to pay the expenses and capital works.

What does affect commercial property is the rate of demand. Low demand for commercial spaces can moderate the rental growth, yet reduce the power of inflation for leases. However, with high-value spaces available, the rate of vacancies remains low — despite economic hardship — and can still sell for moderate or higher costs.

During times of economic recovery, however, real estate returns grew as inflation rates began to grow — which is the space we're in now following the COVID-19 pandemic economic decline. In short, commercial real estate does not follow the trends of other investments such as private equity or venture capital. Moderate inflation increases have little impact on commercial real estate based on historic trends following similar paths of costs versus inflation ratings.

If you're ready to invest in a new commercial real estate property, reach out to us for an appraisal.

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