Investors who stay ahead of inflation stand to profit greatly from commercial real estate.
The explosive growth of hedge funds in the 80’s and 90’s coincided with an investing public seeking alternatives to a volatile public market. Hedge fund managers touted their ability to beat the market in any economic environment through complex derivative strategies and mathematical algorithms. Investors were hooked.
Decades later, the reality is: hedge funds haven’t been able to beat the market consistently.
In fact, for many hedge funds, the only ones making money were the hedge fund managers and not their investors. This was due to exorbitant fees hedge fund managers charged whether their funds made money or not.
The underlying appeal of hedge funds was the ability to zig when the market zags – in other words, profiting even in downturns. Most hedge funds have never fulfilled this promise. But there is one investment class that has – commercial real estate.
It should come as no surprise that since the ’90s, ultra-high-net-worth investors (“UNHWIs”) and institutions such as university endowments have been consistently divesting themselves of hedge funds. They’ve been reallocating their assets to a more reliable recession buster, commercial real estate. Commercial real estate is a crucial component of every modern UHNWI and institutional investment portfolio – often comprising more than 15% of their entire allocations.
Commercial real estate has consistently demonstrated its ability to zig when the market zags, and there are signs the market is about to zag – making commercial real estate more crucial than ever to have in a portfolio.
The economy has been in expansion for more than ten years and is, in fact, in the most prolonged period of expansion in U.S. history. That means a recession is on our doorstep, and there are already signs of cracks in the armor.
In mid-2018, after ten years of steady economic growth and historically low interest rates, inflation began to rise in the states.
Investors who don’t go on the offensive will be blindsided by the twin terrors of recession and inflation. We’re focusing here on strategies for staying ahead of the inflation curve to not only survive but to prosper.
First a primer on inflation. There are two main types of inflation, cost-push inflation and demand-pull inflation.
Cost-push inflation results from the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production. Tariffs and increased labor costs can increase the cost of production.
Demand-pull inflation results from an increase in aggregate demand. Low interest rates that lower the cost of borrowing can increase demand as consumers may be more willing to go into debt to acquire goods.
The two types of inflation have two effects on commercial real estate. Demand-pull inflation can drive the cost of commercial real estate up as demand outpaces supply. This can be positive since as the demand for commercial real estate goes up, so does the ability of landlords to increase rents.
On the flip side, with supply-push inflation, the increase in supply costs can increase construction costs, making the development of new properties more costly. Higher development costs may require owners to charge higher rents to sustain margins. However, higher rents may result in lower demand for newly constructed properties.
Here’s the good news…
For those who stay ahead of the inflation curve, there’s a way to profit from commercial real estate – no matter the type of inflation.
In a demand-pull inflation scenario, the landlords who will be in the best position will be the ones who acquire properties ahead of inflation when real estate prices are lower. Inflation will drive up not only rents but also property prices, so those who wait to acquire properties later when prices are higher will have their margins squeezed. However, landlords who acquire properties before the inflation spike will not only be able to charge higher rents but will be able to enjoy higher profits because they acquired assets at a time when property prices were lower.
Supply-push inflation, like demand-pull inflation, will reward the early movers. Investors who already own property will be the ones who will be able to profit from supply-push inflation when construction slows because of higher costs. Once again, landlords will be able to command higher rents, but this time because of constrained supply and not because of outsized demand under the demand-pull scenario.
Either way, it’s the early adopter investor who already owns property and not the Johnny-come-lately that will benefit the most from inflation.
A word of caution. Landlords who already own property but want to take advantage of higher rents from inflation must adopt one or more key strategies to take advantage of the higher rents.
One strategy for charging higher rents is including an escalation clause in the lease agreement allowing for the escalation of rents tied to inflation.
Another strategy would be the use of short-term leases giving the owner the ability to raise rents on future leases upon the expiration of current leases.
The signs of creeping inflation in the U.S. economy are already revealing themselves. Those who stay ahead of the curve and invest before an inflation spike will be able to take advantage of higher rents when this happens and enjoy higher profits from properties that were acquired before this anticipated spike.
So get moving now before the market zags! Partner with Four Peaks and get ahead of inflation so that you will be positioned to benefit when it hits.