Commercial real estate has the advantage of providing landlords with a high income, usually a higher return than residential real estate, provided your tenants stay, rents can be increased regularly to keep pace with inflation , and when finances are at stake, interest rates are not too high.
A commercial owner, the Alternative Income Reit (AIRE), has just released its third quarter results which highlight a resilient and well-managed commercial portfolio of 19 freehold and long-lived properties. According to The Investor Chronicletheir portfolio continues to increase in value with its increasing and contracted rents.
This is because 93% of the company’s rents are reviewed periodically, based on only upward rent reviews inserted into all leases, keeping them easily in line with inflation.
In the last quarter, contractual rents increased by nearly 5% on a like-for-like basis to £7.22 million.
And 58% of the group’s owner revenue is expected to be reviewed over the next 12 months, which the group no doubt appreciates, given that RPI and CPI metrics will likely hit double-digits in the fall. It’s an inflationary backdrop that the UK hasn’t seen in over 40 years.
In addition, the group is fortunate to have a diversified portfolio of tenants spread across some of the most dynamic sectors of the economy, in particular retail warehousing and industrial real estate.
Investors have bought a record number of commercial properties in the past 12 months, looking for bargains after the pandemic carnage. They were encouraged by increased tenant demand and a shortage of space in some key areas as construction and development work stalled during the recession.
Some large bets were placed in commercial real estate as investors viewed this asset class as a good hedge against inflation. The strategy offers possibilities for higher valuations, provided the group can retain good tenants and continue to increase rents in line with inflation.
The alternative argument
With inflation at its highest in four decades, some industry experts question the wisdom of relying on the strength of commercial real estate’s ability to fully hedge against the ravages of inflation .
The traditional view that commercial properties are a good inflation hedge has been valid in the past, as landlords were protected when they could regularly raise rents to outpace price increases.
Investors’ case has been helped by some of the same forces that fuel inflation: rising labor costs and supply chain shortages that limit the amount of supply, a lack of new buildings and developments that would otherwise compete with existing owners.
But, with recent signs of a slowdown in the economy, big business profits and hence demand for industrial units, Amazon being a prime example, with its slowdown in warehouse expansion, some investors begin to withdraw money from real estate because they see less value in it as a hedge against inflation.
They see more potential damage to the commercial real estate sector in the event of a significant downturn in the economy and persistent inflation, which will drive up long-term interest rates. Rising rates will inexorably lead to higher financing costs. It will then be more expensive for building owners to refinance and values will fall.
The appeal of commercial real estate as an inflation hedge could suffer if the focus is on interest rates. It is certain that interest rates will continue to rise as the Bank of England begins to cancel its support for bond purchases and seeks to calm inflation.
The bank will likely continue to raise rates in the face of a slowing economy – a stereotypical stagflation link.
Some argue that even if rates rise due to inflation, a well-diversified commercial real estate portfolio, with good paying tenants, is still a good bet. But the pandemic has introduced forces that are quite unique: supply chain shortages and chronic labor shortages due to early departures from the labor force, this could mean that inflation could be with us for an extended period.
Landlords may not be able to keep raising rents if tenants simply cannot afford to pay more.
Whatever happens in the future, it’s far better to put the money to work than keep it under the mattress, where inflation will eat it away.