In 2021, the Consumer Price Index jumped 7%, the largest yearly increase since 1982. The monthly increase in December 2021 was the largest in 40 years. Most economic experts believe that this inflationary period is a result of supply chain issues due to the COVID-19 pandemic, but early predictions of a purely transitory inflationary period are proving inaccurate. In late 2021, Fed Chairman Powell predicted that inflation will continue well into 2022. Observers predict the Fed will raise interest rates in March 2022 and at least two more times during 2022.
For commercial real estate, the persistence of inflation can be good or bad, depending on where you sit. And it also matters if inflation is a result of strong economic growth, which most experts agree is behind today’s inflation, or “stagflation” which is caused by high unemployment and stagnant demand. In today’s type of inflation, existing developed properties will continue to shine as inflation persists. There are several reasons for this. First, for owners who locked in low mortgage rates over the last few years, the value of their property will rise during inflation but the cost will remain the same. Second, inflation in the cost of goods and labor will depress new construction, thereby preserving the market share of existing properties. Fewer new properties coming online also means more demand for existing space, thereby raising rents. Accordingly, we can expect landlords to find shorter-term leases more attractive, so as not to miss out on a rising rent environment.
For developers, buyers, and tenants, the picture is not nearly as rosy. The higher cost of materials and labor will mean less projects are built. The increased attractiveness of existing projects will mean fewer properties come on the market, making new investment more difficult and more expensive. Tenants will have trouble finding space that they can afford. However, tenants already locked in to long-term leases with low periodic rent increases will benefit (and their landlords will correspondingly suffer) as their rents fall further below the market over time.
Many commercial real estate investors today are too young to remember the last bout of high inflation in the 1980s. With high inflation following closely on the heels of the COVID-19 pandemic that is still with us, it presents another novel issue to be considered in any real estate investment decision. However, investors should be careful not to let inflation be the sole driver behind any investment decision, as studies have shown that when evaluating total real estate returns, periods of high growth and low inflation are the best for commercial real estate, and that economic growth is much more relevant to portfolio performance than inflation.