Following the pandemic, inflation has risen worldwide, and the United States has seen one of the biggest annual inflation rate increases in decades.
The US Consumer Price Index increased 8.5 percent for the 12 months ending July 31, 2022, making it the largest increase in 40 years according to the U.S. Bureau of Labor Statistics.
What does this mean for individuals and businesses throughout the nation? It means rising prices are causing capital market disruption and reconsideration of investment and financial decisions that support long-term financial health.
Basic Impact and Outcome of Inflation:
There is a compounding impact to inflation that leads to concerning outcomes:
Inflation impacts the consumer price index, which means rising costs for food, energy, and commercially available goods.
This is problematic because cost modeling in almost every commercial or retail context relies on price indices and related data.
The result: Forecasting methods are disrupted when inflation becomes severe, making it very difficult for businesses to predict costs and plan accordingly.
Perhaps most important, rising inflation lowers purchasing power, lowers the value of savings and Treasury notes, and often long-duration assets.
In times when inflation is expected to rise significantly, most businesses and individuals look for recession-resistant investments. One of the most popular options is real estate. Real estate assets are well known for keeping up with inflation and are one of the few investment strategies that may retain value even during fluctuating inflationary periods.
Office REITs and a CRE Investment Strategy
The public’s expectations for standardization of work from home and hybrid arrangements created operational challenges for owners of office buildings. But the truth is, since 2021, returning to the office has been the dominant trend.
By mid-2020, as many as 75 percent of remote employees stated they were eager to return to the office. By mid 2022, most all enterprise-level companies have returned to the office.
Commercial real estate has been remarkably resilient through the past five decades. Even after the 2020 COVID-19 pandemic, it has rebounded and, in some regions, even grown. Top-rated suburban areas — including Austin, Dallas, and Fort Worth — are experiencing explosive growth, which increases the demand for office buildings.
One note of importance can be gleaned from this; commercial real estate investments have historically proven to be an inflation-resistant strategy posing significant market opportunity and noteworthy returns for commercial real estate investors.
Supply and Demand
Supply and demand are relevant considerations for buying office properties as an inflation-resistant investment strategy. For example, in regions of Houston, the office market was considerably overbuilt in the 1980s. Some of the development was never adequately absorbed, which resulted in too much supply and not enough demand.
Now that the region is experiencing record-breaking growth, years of leveraging resources to lease-up assets is paying off. For new entrants into CRE investing in this area, the timing has never been better, as demand has never been higher.
After climbing to a historic peak of 18.63 percent 1981, 30-year fixed-rate mortgages have trended downward. With rates at an all-time low in 2021, what resulted were record transaction volumes in the recovery period after the worst of the COVID-19 Pandemic.
With central bank monetary policy switching gears in 2022, CRE interest rates appear to be increasing, and most economists agree that they will continue in that direction. Policymakers have already raised rates significantly which are the first increases of their kind since 2018.
Even with a rebounding economy, uncertainty around interest rates typically results in a slowdown of new development and more attention to operating properties. Raw material costs are at an all-time high, not to mention construction labor shortages, making development projects a challenge.
These dynamics force an important conclusion: there is likely less risk and more security in investing in existing real estate assets.
Suburban Office vs. Alternative CRE Investment Strategies
Whether just entering the market or seeking to diversify, you have an array of considerations with CRE investing.
At Hartman, our strategy is to purchase low-occupancy properties in need of capital improvements and repositioning. For these efforts, we routinely see an increase in occupancy, and subsequent cash flows stabilize after improvements have been made. This is the cornerstone of a value-add investment strategy.
Value-add investing has proven to be a sound strategy for decades, especially in desirable suburban areas close to major metroplexes like Dallas and Houston.
Real estate sponsors are not immune to the ways in which inflation can impact financing, but the possibilities for benefitting from real estate investments during high inflation, especially for suburban offices, are many.
Case for Suburban office
All this information and current market understanding coalesce into a winning case for investing in commercial real estate, especially suburban office buildings. Real estate sponsors with these holdings are likely to see encouraging gains in both the near term and long term.
With increasing revenue and physical asset appreciation, real assets have historically responded favorably to inflation. A quantifiable trend of rebound in global trade, passenger travel, office occupancy, and attractive valuations could mean significant inflation protection through investing in commercial real estate.
The case for the suburban office is twofold:
- There is strong demand from smaller business-owner tenants who are looking for amenities, an affordable lease rate, and shorter lease terms.
Here is a quote from the Greater Houston Partnership:
“82 percent of the firms operating in the Houston metro area have fewer than 20 employees. Together, these businesses employ just under 400,000 workers, or about 14 percent of the regional workforce. Nearly 97 percent of businesses in the region have fewer than 500 employees— the standard to be considered a small business—and these collectively employ 44 percent of the region’s workforce.”
This is the prevalent, fast-growing tenant base in Texas, and they want a suburban office.
- There is a growing call for shorter commute times. This is achieved by working at an office located nearer to home. For most, that means a suburban office.
Post Pandemic Priorities and trends
The suburban office is coming out on top in post pandemic priorities.
Companies want to create an in-person work experience that is more flexible and “closer to home” for employees. This describes the ideal need for suburban offices. It is an option that represents the best of both worlds, supporting the benefits of face-to-face interactions with more flexible accommodation.
This is not a temporary imperative from employees, which means the demand for suburban office buildings is not going anywhere: it will remain, making it not only an inflation-resistant investment strategy, but a future-proof one.
Additionally, the uncertainty of the country’s economy is creating a dynamic in which businesses sign shorter-term leases than in the past. This can benefit office owners by potentially hedging inflation in the future with the ability to increase rents and renewals based on the market.
Why is Capital Flowing to CRE?
There are numerous catalyzing factors behind capital flowing into commercial real estate.
For instance, one well-known sector for the capital flowing to Texas is the burgeoning technology and life sciences business. Because central Texas has some of the fastest-growing collection of companies in those fields.
Another sector responsible for a capital influx into CRE is increased uncertainty in foreign markets. The United States has a reliably strong infrastructure and optimistic economic forecast. Foreign capital is flowing into CRE in the United States because of this and the fact that other countries are also seeing rising inflation. There are also current geopolitical threats throughout eastern Europe and Asia, making the U.S. a more appealing choice for investors.
A last compelling reason is an internal migration within the United States. People are relocating in record-breaking numbers due in part to the disruption of COVID-19, inflation driving up cost of living, supply chain issues, and more.
CRE capital is flowing more freely than in previous years, but it is also important to identify where it is being used.
Where is CRE Capital Going?
As previously mentioned, not all types of commercial real estate are equally valuable when it comes to protecting against inflation. There are some current dynamics in various property types that require consideration.
- The retail environment continues to shift with the competition of online merchants. However, urban centers are experiencing high financing activity for retail properties, viewed favorably by lenders in growth markets.
- Hospitality is benefiting from resumed business and leisure travel, and hotels in many areas of the country are undertaking renovation projects and planning for growth.
- Multifamily real estate also rebounded after 2020, but now shows drastic cap rate compression. Some bought at higher valuations and are now undercapitalized to make improvements and retain tenants.
- Office has historically been seen as “safe harbor,” less susceptible to market volatility, and in some cases, capable of benefiting from inflation through rent rate increases.
Commercial real estate has historically been a strong protection against inflation. Based on current market conditions, rising consumer demand, and a horizon of possibilities there remains high potential for long-term wealth creation.
Hartman is a sponsor of The DI Wire, and the article was published as part of their standard directory sponsorship package.