The Effects of Inflation on Commercial Real Estate

It is evident that there is a direct correlation between inflation and the pricing of commercial real estate. Often, the “cure” to inflation is an increase in federal interest rates which have a direct impact on commercial real estate valuations.  Economists have been expecting an increase in interest rates but were not expecting the federal government’s recent suggestion of three potential hikes in 2022.  Additionally, there are rumored hikes in 2023, and more in 2024.  The message is clear: due to the rapid inflationary pressures, driven largely by supply chain disruptions, the Federal Reserve has an aggressive plan to increase these rates.

Inflation, an economic term that refers to a general increase in the pricing of goods and a corresponding decrease in the purchasing power of the individual, has been weighing heavily on consumers as of late.  In November 2021, the annual inflation rate hit a record year-over-year high of 6.8%; the fastest rate of inflation growth in over three decades. We can attribute the cause of inflation to the perfect storm brought upon us by the Covid-19 pandemic. Federal banks dropped their interest rates to all-time lows, constriction in the supply chain, and volatility in consumer spending behavior has led to an inevitable loss of purchasing power.

Historically, when inflation drives an increase in prices and wages, we see a rise in rents and subsequent values. Commercial real estate valuations are partially based on the net income each asset procures. With these increases, we should expect to see a corresponding rise in rents and expenses, but the two don’t trend hand in hand. Often there is an increase in the expense of a property before an increase in the rental income, inevitably lowering the net income potential and value of the asset.  With increasing forecasts of protracted federal interest rates hikes alongside high inflation, the commercial real estate market can expect to see a potential slowdown in growth and transactions in the coming years.