Inflation seems to have fallen off the radar for some investors, but William McCarthy, CRE, the global chair of The Counselors of Real Estate and the president of W.P.J. McCarthy and Company Ltd., says that is a mistake. Due in part to an aggressive monetary policy, the inflation rate now hovers around 3%, but is still above the Fed's 2% target.
Inflation has a permeating effect on commercial real estate investors. It increases operational costs and interest rates, putting downward pressure on asset values. According to McCarthy, that's led to an environment of uncertainty, but one that hasn't completely quashed investment and development activity, just made it much more cautious.
Festering Uncertainty
While commercial real estate investors and developers are not fortune tellers, they do work very hard at forecasting how the market will evolve. A market with rising inflation clouds the crystal ball, making it difficult to underwrite investments or development projects with a reliable exit strategy.
William McCarthy, CRE, global chair of The Counselors of Real Estate
Rising interest rates are the primary problem. "Interest rates and inflation generally rise together, and they fall together," says McCarthy. "If investors are trying to make decisions with regards to the long term, it's going to be very hard."
Inflation has been resilient. According to McCarthy, analysts predicted that inflation, along with interest rates, would level off in 2023. "Certainly 2024 was supposed to be a year where we might even see drops in interest rates. But now, I think that there will be more rate hikes ahead, even if it's only 25 basis points," says McCarthy.
The stagnant inflation has created rampant uncertainty for investors trying to make reasonable estimates about the future. In addition, McCarthy says that inflation has increased present-day operational costs and business-related expenses, hurting both current investments as well as future prospects.
Investors Take Cautious Steps Forward
Inflation is a thorn, and it has certainly suppressed investment volumes, but McCarthy still sees "a tremendous amount of real estate activity." Through the uncertainty, investors are taking cautious steps forward to secure deals. In particular, McCarthy has seen investors pursuing opportunities in high barrier-to-entry markets or assets, with the hope of buying at a discount or, at least, benefitting from appreciation on the other side of a downturn.
"That's when there's a lot of activity that we don't necessarily see," says McCarthy. "I still see a lot of people working through their pro formas and being very careful and cautious while waiting for an opportunity to develop again."
Costs and building use have both become critical to the analysis of prospective deals. Investors are doing deep due diligence on operational costs and including cost increases over the near term due to inflation. In addition, the building must serve an essential purpose to support potential changes in demand as a result of economic hardship.
This thorough underwriting strategy is helping investors absorb higher inflation and market uncertainty. It's giving investors confidence to move forward. "There is uncertainty, but it doesn't mean that the market shuts down," says The Counselors of Real Estate's McCarthy. "Real estate is never stagnant."
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Kelsi Maree Borland
