Inflation is increasing in Canada in 2021. After a turbulent year in 2020, increases in inflation are a good sign pointing towards the market recovery to come. Year over year data is consistently showing unexpectedly high inflation gains, hinting that the market is stronger than expected and only getting better.

What does this mean for your investment portfolio? Specifically, how does inflation affect commercial real estate (CRE) in Canada?

CRE – Hedge Against Inflation or Loss Magnet?

Real estate is considered as one of the best assets to protect your portfolio from inflation. The income earned from CRE rentals can keep paying out even when stocks and bonds start to lose value.

While it’s not a risk-free investment, an appropriate amount of CRE in your portfolio can reduce your overall risk, especially during periods of inflation.

Why is CRE good during inflation? And what’s the downside to purchasing CRE as an investment?

Advantages of CRE:

Income generation—Properties that can generate cash are more valuable when inflation increases. This is because Much of the value of CRE is based on how much revenue it generates, reducing the value loss from inflation.

Rents can also be raised to keep up with the pace of inflation.

Low interest—With mortgage interest rates below 2.5% for many properties in 2020, mortgages are a relatively cheap loan. High inflation can actually make your mortgage cost even lower and your property value proportionately higher as the value of the cash used to make payments is diluted.

Diversification—When your financial investment instruments (bonds, stocks, etc.)  are losing value because of inflation, commercial real estate property is good way to diversify your assets.

Disadvantages of CRE:

Strong market reliance—CRE relies on businesses or individuals having the need for a rental space and being able to pay for it. If for some reason these two factors are threatened by market conditions, your investment can lose value quickly and become unsustainable.

Capital requirements—To purchase and maintain CRE properties, you need a large capital investment. The upfront investment may be too large for smaller investors to manage.

While the cashflow from the property is often enough to sustain maintenance costs, there may be occasions where a significant capital injection is required.

Lack of liquidity—It’s difficult to get your money out of investment properties quickly. Sales take a long time. In poor market conditions, they can take even longer.

How Inflation Affects CRE

No matter how good of a hedge it is against inflation, CRE doesn’t provide a perfect shield. It is still greatly affected by CRE in these way and others.

Rent Lagging—There is lag time between changes in the market and the changes you can make to your rental property price. You can’t change rental rates immediately, meaning you could lose money while you wait for a time you can increase rents to match increasing inflation.

Maintenance Costs—As you deal with the dilution of your income, you’ll need to continue paying for maintenance, including the wages for your employed staff. Maintenance and labour costs go up with inflation.

Construction Costs—If you are still constructing your building or you’re modifying/renovating, you might find the cost for construction increasing with inflation. As money gets diluted, the cost of both goods and services goes up to match the increases in cost of living.

New developments and renovations are more challenging the more inflation goes up. Materials like lumber, steels, or cement all increase in price, potentially exceeding your existing budget and making it more costly to do what you want.

Changing Interest Rates

If you’re borrowing under a variable loan structure, you may experience steady increases in the mortgage rate you’re paying on your loan. Inflation has little to no negative impact on fixed-rate mortgages.

Final Thoughts

Despite the potential for increased costs and dilution of value of rental payments, CRE still makes a good pick for your portfolio when you’re considering how to negate the impacts of inflation.

To learn more about inflation and how it affects your commercial real estate property, please contact one of our consultants at 1 800 980 6668 for further information.