In February of 2022, the annual inflation rate in the United States accelerated to 7.9% – the highest since January of 1982.1 The Consumer Price Index (CPI) also had the highest increase in 40 years.1 While the Federal Reserve originally forecasted inflation to ease towards the end of 2022, it now appears our high and persistent inflation will be with us for some time, as U.S. Treasury Secretary explained in a recent interview.
“We’re likely to see another year in which 12-month inflation numbers remain very uncomfortably high.”
-Janet Yellen, cnbc.com, March 10, 2022
If you’re a real estate investor, you may wonder how this rising price environment will impact your current holdings and whether you should make some adjustments to your portfolio. Here are a few things to consider before you make your next move:
How Inflation Affects Real Estate
Extended inflationary periods affect the real estate market in various ways; Some of the most significant include the influence on property values, rents, and financing.
Labor and construction material costs tend to rise during inflationary episodes, which can slow the development of new projects. This often creates a supply shortage for many different real estate assets, fueling demand and increasing property values. So, commercial real estate investors could benefit from property appreciation during rising inflation.
Many commercial property contracts contain escalation clauses, enabling owners to raise rents as their labor and property management costs increase. Annual increases are often tied to increases in the CPI. And multifamily property leases, written for shorter terms (6-12 months), allow owners to raise rents quickly, which may be at rates higher than inflation.
Inflation can impact commercial real estate investors in either a positive or negative way. For example, property owners who secured long-term fixed financing in the last few years when rates were at all-time lows will most likely avoid the need to refinance as rates increase. Conversely, owners who need financing during rising inflation will pay higher rates, typically raising their operating costs.
A Time to Buy?
While real estate still has its own risks, you may be happy to know real estate is an inflation hedging strategy. Real estate owners likely have seen property value increase over the last year and may be wondering if this would be a good time to sell.
Many other investment property owners may be weighing that same decision. One compelling strategy for potential sellers to maximize gains today yet not get clobbered with capital gains tax is to consider a 1031 exchange.
The 1031 exchange is a provision in the Tax Code, allowing investment property owners to defer capital gains and depreciation recapture taxes when exchanging an existing property for a “like-kind” replacement property.
We believe tax deferral should be increasingly important during high inflationary times, when appreciated property values may be at their highest.
We hope you have found this introduction on inflation and commercial real estate helpful. In Part II, we’ll discuss several investment concepts in further detail, including a deeper dive into four strategies that may help an individual properly allocate real estate investments during this period of inflation.
For more info, contact our team to schedule a consultation.