Should CRE Plan for Permanently High Inflation?

If you think high inflation is a temporary thing and the world will be back to pre-pandemic normal, you’re at odds with some of the world biggest bond investors, according to a Bloomberg report. They figure the Fed’s goal of 2% inflation is largely a pipe dream, which is why they’ve loaded up on inflation-protected bonds, exposure to commodities, and keeping plenty of cash—yes, cash—on hand.

What sustained low inflation during a long stretch of expanding globalization were cheap energy and labor. (Long-term easy monetary supply that central banks kept hoping would juice growth would probably be a sober addition.)

But time for a deep breath. Look up the historical annual inflation rate in the U.S. Plenty of stretches had inflation rates of significantly above 2%, the Fed’s target. Commercial real estate didn’t fall apart.

What can throw people off is looking at the recent past. “To have a market, with low interest rates for more than 12 years, does not follow logic nor the cycle that existed for decades,” Kevin Swill, CEO at Thirty Capital Financial, tells GlobeSt.com.

However, moving back to normal doesn’t mean it will be painless, particularly given the investment strategies that followed those low rates. “Levered investors might struggle to cover debt service and secure loans if cap rates spreads to interest rates narrow,” said DWS Group’s U.S. Real Estate Strategic Outlook for July. “Real estate leasing could also retrench amid job losses and dwindling profits. Indeed, recessions have been the proximate cause of every broad-based decline in real estate prices since the early 1960s.”

Also, higher inflation will mean ongoing higher interest rates as the Fed tries to slow growth. That will affect the entire financing process and its cost.

“The real estate industry runs on credit and the fundamentals of real estate are out of balance,” says Peter Tuffo, president of the south region for Suffolk Construction. “Real estate investment is tied to confidence, and some projects are simply not penciling out. Real estate responds negatively to higher risk.”

“This situation has a significant effect on bridge and short-term loans that become more expensive for developers,” Rogelio Carrasquillo, managing shareholder and cofounder at Carrasquillo Law Group, tells GlobeSt.com. “As a result, programs such as EB-5 and other alternative sources of financing that would not be considered otherwise, become viable alternatives for the financing and development of commercial real estate projects.”

But even then, it’s not all bad news because “inflation could also mean higher rent growth and NOI that could offset some of the impact of higher interest rates,” says Zachary Streit, founder and managing partner at WAY Capital. Also, “We are seeing the trend of more deals getting done with fixed rate financings and some sort of partial recourse or creative financing structures like PACE to offset today’s higher rates offered by floating rate lenders.”