Investments in CRE Could Rise Over Inflation Concerns – Here’s Why Boston Could Be a Hotspot
Posted By: Boston City Properties
Since the onset of the pandemic in early 2020, prices for many common goods have noticeably increased. For everyday consumers, a decrease in spending power is a primary concern. Investors, however, have even more to worry about. During periods of high inflation, which we could be entering into now, the value of investors’ future cashflow streams erodes. In turn, their purchasing power relative to inflation drops, and their capital doesn’t go as far because the cost of goods and services is rising faster than any returns they may realize.
If you’re an investor, you’re probably already on alert for a potential uptick in inflation. We’ve already seen sustained increases in the prices of everyday goods like used cars, gasoline and lumber. In fact, skyrocketing lumber prices have increased the cost to build a new home by an average of $36,000. However, the question is whether this is just a blip on the radar due to the pandemic and other unusual forces or if this is the beginning of a long-term, ongoing period of rising prices?
Regardless of what the answer to that question ends up being, here’s a fact: The U.S. has been in one of the most extended periods of low inflation in modern history. As any economist worth their salt would say, this too shall pass. When it does – when inflation spikes up again over a long period – will your investment portfolio be ready?
Savvy investors know that when long-term periods of rising prices strike, it’s crucial to adjust their investment strategies to hedge the resulting inflation. To understand this better, it helps to understand the basics of inflation. Put simply, inflation refers to a gradual increase in the prices of common goods and services over a sustained period. Because inflation can wreak such havoc on the economy, the U.S. Federal Reserve monitors it closely, and the agency has steps it can take to control it.
The Fed tracks inflation trends by monitoring the Consumer Price Index, CPI, a list of commonly bought goods and services. The agency aims to keep inflation between approximately 2% and 3% annually. If the rate dips above or below that range, the Reserve can take actions to adjust it. However, that’s cold comfort to investors, who stand to see their future gains diminish drastically under periods of high inflation.
Why High Inflation is A Big Problem for Investors
Nobody likes high inflation rates; after all, it means paying more for everyday things like a loaf of bread or a gallon of milk. For investors, though, high inflationary periods are especially alarming because they chip away at the value of future cash flow streams. To combat rising inflation, investors have to achieve returns that exceed the inflation rate – and that’s often easier said than done when it comes to vehicles like bonds and equities.
With the possibility of increasing inflation rates on the horizon, investors are wise to seek inflation hedges or asset classes that perform well even in periods of high inflation. “Hard,” or “tangible,” assets often fill the bill – and commercial real estate is one of the strongest, most reliable options. Here are three reasons why:
- Rental Income Increases Under Inflation – When inflation rises, CRE rent prices increase. In turn, as long as operating expenses are kept under control, property values increase too. The increased rental income translates into increased Net Operating Income, NOI, driving property values higher. As a result, an investor’s buying power is not diminished. As long as the property value increases above the inflation rate, CRE serves as an excellent hedge for investors.
- Regular Rent Increases Are Built into Most CRE Leases – As a hedge against potential inflationary increases, most commercial real estate leases include clauses calling for regular rent increases. For example, many leases call for a 2% increase in rent per year. These regular price increases produce rising income, which in turn increases property values. Again, as long as the inflation rate stays below those increases, investors enjoy positive relative returns.
- Scarcity of CRE Causes Price Increases that Outpace Inflation - Especially in high-density real estate markets with limited space – like Greater Boston – commercial real estate prices are partly driven by their relative scarcity. As is well-evidenced across the Boston CRE market for some time, high demand and limited supply prompt rising prices, and this holds true even during periods of high inflation.
Invest in Boston CRE to Hedge Against Future Inflation
Even the most well-versed, well-educated economic experts can’t predict with absolute certainty when inflation rates will spike for an extended period. However, given the climate of the economy – especially in the brave new world of the pandemic – most investors are wise to take steps to hedge against rising inflation now. As outlined above, commercial real estate is one of the best investment vehicles for diversifying a portfolio and hedging against periods of increasing inflation – and Boston has one of the hottest CRE markets on the planet.
Suppose we are entering a period of high inflation. In that case, the higher returns from CRE assets in your portfolio can offset the reduced returns and general volatility inherent to things like equities and bonds during such times. Boston commercial real estate epitomizes the three points highlighted above. First, lease prices for office and lab space, especially, have steadily increased despite the pandemic. Second, leasing and subleasing activity has remained strong, ensuring that many properties are under leases calling for regular rent increases. Third, and finally, prime CRE is genuinely scarce in Boston and surrounding areas. During the third quarter of 2021, the office space vacancy rate fell to 11.1%; the vacancy rate for lab space during that period dropped to 1.6%, an all-time low.
Additionally, demand for CRE, including office and lab space, remains robust across the region. In the third quarter, 3.7 million square feet were being sought by tenants for the second quarter in a row. With demand for lab and life science space expected to remain strong for the foreseeable future, now is the time to invest in Boston CRE to hedge against the very likely upcoming period of increasing inflation rates.