CRE doesn’t exist in a bubble. Changes happening in the local, national, and international markets can all have an impact on the profitability of a real estate asset.

Depending on what’s causing inflation rates to change and how healthy the market is going into these changes, the impact to a specific property can vary dramatically.

Driving Forces Behind Inflation

The impact of inflation on CRE largely depends on the factors affecting inflation. What’s causing the inflation rate to rise or fall?

CRE is affected by many of the same underlying forces that can cause inflation to increase. For instance, strong economic growth can cause higher inflation. When demand increases faster than supply, inflation goes up as the prices of raw materials and finished products both rise. In this case, rising inflation can be good for CRE, since the underlying economic growth will also have a positive impact on the real estate market through lower vacancies, higher rental rates, and long-term value growth.

On the other hand, if the market is facing stagflation (high inflation, high unemployment, and stagnant demand), this can be detrimental to the CRE market. In these situations, landlords may not be able to increase rental rates to keep up with inflation while vacancy rates on commercial properties can be higher.

Before you can understand how inflation is going to affect the CRE market, you have to understand the underlying cause.

Interest Rate Changes

When inflation increases, interest rates can rise in response. Rising interest rates are bad for CRE in the short run, as they can drive up cap rates and reduce the rate of return on a property. This is mostly an issue if you plan to sell in the next few years. During periods of higher inflation, holding an asset may allow the property to act as a hedge against extended inflation.

In the long run, higher interest rates from high inflation could end up benefitting landlords if rental rates also increase. This assumes that economic growth in the market is one of the driving factors of high inflation rates, leading to positive outcomes for CRE over time.

If rental rates have the flexibility to increase with market growth (i.e. short-term leases or leases which are expiring soon), landlords can keep up with market rents and steadily increase the earnings from a property. Higher NOI will cause the property to increase in value, allowing the owner to benefit from equity gains without adding any extra debt.

Market Supply

The impact of inflation changes depending on the existing supply in the market. Tight supply in a specific asset class will cushion that class from many of the negative effects of inflation. With a tighter supply, investors will likely experience lower rates of vacancy.

When the market is oversupplied, investors are more likely to experience higher vacancies if they try to increase rents to keep up with inflation. New and existing tenants may not be willing to pay higher rates if there are other comparable options in the market.

Stay Alert for Changes

Inflation is not always objectively negative or positive. By looking at the market conditions surrounding CRE assets and the variables playing into the inflation changes, an investor can more accurately predict the potential impacts to their own properties. Contact the CCR team today to discuss how the market is affecting your assets.