Inflation in the Nation
It seems that inflation is at the forefront of everyone’s mind. A quick LinkedIn search of this buzzword will bring to your attention enough content to keep you scrolling for days with branches of the rabbit hole opening up with each new topic: “interest rates”, “the pending recession”, or “calculating inflation” the questions are endless. The latest CPI figure for the US Bureau of Labor Statistics sets inflation as of June 2022 at 9.1%, the highest many of us in the younger generations have seen in our lifetime.
With so many panic-inducing articles surrounding the topic of inflation, it can be easy to go into a tailspin of doubt and fear. However, some sources look past this speculation with a much more optimistic and long-term perspective.
For example, financial journalist Jamie McGeever wrote in a recent Reuters article that “core” metrics of measuring expected inflation are cooling, citing that 5-year and 10-year Treasury Inflation Protected Securities (TIPS) have seen a steep decline over the last several weeks. The five-year/five-year forwards have also declined. These and other important financial instruments are used to predict markets’ expectations for inflation and current indicators are not suggesting that inflation will be a long-term concern.
With contending opinions on the outlook of the financial future, many wonder what will happen in the short term and if monumental economic corrections are, in fact, inevitable. Through all this uncertainty, there are measures to help counter the short-term effects of inflation, help build a recession-resilient portfolio, and create monthly cash flows. Our preferred solution is real estate.
The Long-Term Hedge
There is no better hedge against inflation than owning real estate. Rental rates will always follow consumer price index (CPI) trends. As inflation increases, landlords adjust rents to fight against inflation and the devaluation of the dollar. Every dollar collected through rents is a dollar that is inflation-protected and purchasing power is preserved
Multifamily real estate investments see this adjustment the quickest because most leases in residential assets are not much more than a year in length. This allows for the landlord to quickly adjust rental rates to mitigate the operational expense increases. Over the course of a year, landlords might see inflation affect line item expenses such as labor and utilities, but an inelastic demand for housing allows the landlord to pass these cost increases along to the tenant through rent increases at renewal. Think of a residential rental as having a quick knee-jerk relationship with inflation.
Commercial Single Tenant, Net Leases (STNL) assets protect against inflation in a different way with a long-term lease and the security of a corporate guarantee from the tenant. Additionally, the three main inflation-impacted expenses related to owning real estate (building operations and maintenance, property taxes, and insurance premiums) are paid for by the tenant, not the landlord. The combination of a long-term lease, corporate guarantee, and tenant-paid expenses provide the property owner with stability and security in times of aggressive inflation.
STNL vs. RESIDENTIAL
When considering STNL COMMERCIAL versus RESIDENTIAL inflation-adjusted returns, differences between the weaknesses of the two asset classes can help illuminate why we believe an STNL asset is a more reliable investment in times of inflation. Residential rental rates are affected by costly primary expenses of vacancy rates and repairs. As inflationary environments are typically coupled with recessionary economics, the likelihood of unplanned vacancy and costly physical improvements required to entice renters increases. Meanwhile, commercial STNL assets benefit from no economic vacancy for the initial lease term, with high probabilities of the tenant exercising options and staying longer. The challenge for STNL assets comes in the fixed escalations, where the landlord lacks the flexibility to increase the rents if the inflation rate outpaces the contractual escalations. The greater the spread between long-term inflation and the fixed escalation rate, the more a STNL asset experiences reduced inflation-adjusted returns. For STNL assets, the lost return to inflation can be recovered when new leases are signed, extensions negotiated, and rent escalations are agreed upon as the new lease is set to market rates.
While there is no asset class that has every checkmark in the positive column, commercial assets, with long-term, net leases and corporate guarantees provide an ideal mix of attributes to provide a hedge against inflation: security and stability through turbulent economic conditions, protection from cost and expense increases, and return escalations to keep pace with inflation. And don’t get us started on the tax benefits of real estate.
Millcreek Commercial offers fractional, Tenant In Common (TICs) property options that are 1031 exchange compliant and SDIRA approved. For a no-commitment consultation with a qualified member of our team, please schedule a call here.