To succeed in commercial real estate, it is essential to understand the interplay between inflation and interest rates and how it directly impacts potential deals. These economic factors heavily dictate market conditions, influencing everything from property values to investment strategies. Given the current economic climate with fluctuating inflation and interest rate trends, understanding these concepts is more important than ever.
Unravelling Inflation: A Multidimensional Perspective
Simply put, inflation is the pace at which the general price of goods and services increases, eroding overall purchasing power. It's measured by indices such as the Consumer Price Index (CPI) and the Producer Price Index (PPI) and is an important economic indicator to watch.
The main causes of inflation
Demand-Driven Inflation: A surge in demand in a growing economy
Mechanism: Demand-driven inflation occurs when the overall demand for goods and services in an economy exceeds the amount that is supplied. This imbalance usually occurs in rapidly growing economies. Triggers: The main factors that cause demand-driven inflation include increased consumer spending due to rising disposable income, expansionary fiscal policy (e.g. government spending), and easy monetary policy that leads to lower interest rates.
Cost-push inflation: The impact of rising production costs
Mechanism: Cost-push inflation is caused by rising production costs, which producers pass on to consumers in the form of higher prices. This type of inflation can occur independent of consumer demand. Triggers: Major drivers of cost-push inflation include rising raw material costs (such as steel and timber), rising labor costs (due to rising wages), and rising overhead costs (such as taxes and compliance costs).
Endogenous inflation: the wage-price spiral
Mechanism: Endogenous inflation is tied to worker and employer expectations. It is a self-sustaining cycle in which workers demand higher wages to keep up with rising costs of living. Employers pass on these increases in labor costs to consumers through higher prices. Trigger: This type of inflation is often associated with a strong labor market in which employees have the power to demand higher wages. It can be reinforced by union negotiations and minimum wage policies.
Interest rates: more than just a cost
Although interest rates are often perceived simply as the cost of borrowing money, their influence goes far beyond that, permeating many aspects of economic policy and personal financial decisions.
The Multifaceted Role of Interest Rates
Monetary policy tools: Central banks use interest rates as their primary tool for controlling monetary policy. By adjusting interest rates, they can either encourage borrowing and spending to stimulate economic growth or cool an overheated economy to control inflation. Economic equilibrium: Interest rates act as a lever to balance economic activity. During periods of high inflation, central banks may raise interest rates to reduce consumer spending and investment, slowing the economy and stabilizing prices. Conversely, lowering interest rates can make borrowing cheaper during economic downturns and stimulating economic activity. Signals economic health: Interest rates also signal the state of the economy. Low interest rates can indicate efforts to stimulate growth in a sluggish economy, while high interest rates can suggest measures to cool inflationary pressures in a booming market.
Determinants of interest rates
Central bank policies: Interest rates are most directly influenced by the decisions of central banks. These institutions set benchmark interest rates, such as the Federal Funds rate in the United States, which serve as the basis for the interest rates they charge each other and, ultimately, consumers. Economic conditions: A wide range of economic indicators, such as GDP growth, employment statistics, and inflation, help guide central banks' interest rate decisions. High inflation can lead to higher interest rates, while a recession can lead to lower interest rates. Credit market demand: Supply and demand dynamics in the credit market also play an important role. High borrowing demand can lead to higher interest rates, while an excess supply of funds can lead to lower interest rates. Global financial markets: In an interconnected global economy, international events and trends can affect domestic interest rates. For example, a country's interest rates may be adjusted in response to changes in a major economy or a global financial crisis.
The broader impact of interest rates on the economy
Impact on Savings and Spending: Interest rates directly affect individuals' savings and spending decisions. Higher interest rates encourage savings and greater returns, while lower interest rates make saving less attractive and spending and borrowing more attractive. Investment Decisions: Borrowing costs affect businesses' investment decisions. Lower interest rates reduce the cost of financing new projects, expansions and acquisitions, which can lead to increased business activity and economic growth. Consumer Credit: Interest rates determine the cost of various forms of consumer credit, including credit cards, car loans and personal loans. Fluctuations in interest rates can affect consumers' borrowing costs and spending patterns. Exchange Rates: The level of interest rates relative to other countries can affect the value of a country's currency. Higher interest rates attract foreign capital, which increases demand for the currency and can lead to an appreciation in value, affecting international trade and investment flows.
How inflation and interest rates affect real estate transactions
Inflation is not just a background indicator. It is a dynamic force that directly impacts real estate values, alters the trajectory of construction costs, and reshapes rental market conditions. At the same time, interest rates, as a lever on borrowing costs, affect the feasibility of real estate investments, determine loan terms, and regulate market activity. The intersection of these economic forces creates complex interactions that smart investors, developers, and analysts must navigate to optimize their position in the commercial real estate market.
Impact on property values
Rising Inflation: Inflation is typically considered positive for CRE values. As the cost of living and construction rise, the perceived value of real estate assets also rises, making them attractive as inflation hedges. This is especially true for properties with leases that have rent increases linked to inflation indexes or shorter lease terms that adjust more frequently. Market Fluctuations: The relationship between inflation and property values varies depending on the type of property. Retail and industrial properties may respond differently to inflationary pressures due to different consumer and business spending patterns.
Impact on rental income and operating costs
Rental income: In many commercial leases, rent is indexed to the rate of inflation, allowing landlords to increase rent in line with inflation. This protects rental income and may increase it in the long term. Operating costs: For property owners, operating costs such as utilities, maintenance and property management also tend to rise with inflation, which may offset some of the benefits of increased rental income.
However, if rents are fixed and not indexed to inflation, landlords may find it difficult to maintain or increase rental income over the long term. In such cases, the rent amount remains constant throughout the lease term, regardless of changes in the cost of living or market conditions. This can have several implications for landlords:
Reduced Real Income: As inflation rises, the purchasing power of fixed rental income declines. This means that over time, the real value of the income received from tenants may decrease, reducing profitability for landlords. Reduced Competitiveness: If local market rents rise due to inflation or improvements in the local market, fixed rent landlords may find their properties less competitive compared to others that adjust rents in line with current market rates. This can make it harder to attract and retain tenants, especially if those tenants perceive a higher value in properties with more modern amenities and/or competitively priced properties.
To address these challenges, landlords may employ several strategies, such as incorporating periodic rent review clauses into leases, negotiating shorter lease terms to allow for more frequent rent adjustments, or including other revenue-generating clauses in leases (such as percentage rent based on tenant sales).
Implications for investment strategy
Risk assessment and strategy adjustment: Investors should consider inflation as an important factor in their investment strategy. In a high inflation environment, investors may prefer properties with shorter lease terms that allow for regular rent adjustments and properties in sectors that are less affected by economic downturns. Diversification: Diversifying investments across different property types and geographies can help mitigate the risks associated with inflation. Cost of capital: Inflation often leads to higher interest rates, increasing borrowing costs. This should be factored into the investment decision-making process, especially when assessing the viability of leveraging for property acquisitions.
Impact on lending and investment
Lending and Borrowing: Interest rates are a key determinant of mortgage rates and directly affect the affordability and attractiveness of real estate financing. Low mortgage rates stimulate real estate demand, while high rates discourage it. Real Estate Investing: The attractiveness of CRE investments is closely tied to interest rates. Lower interest rates make real estate more attractive due to lower financing costs and potentially higher returns compared to other investment types. Financing Structure: The choice between a fixed rate mortgage and an adjustable rate mortgage depends on current interest rates and expected future interest rates. In a rising interest rate environment, a fixed rate loan may be more attractive as it allows you to lock in a lower interest rate.
Mastering the rhythm of the market
Understanding and adapting to the nuances of inflation and interest rates is crucial for those in the commercial real estate space. These economic forces shape the landscape of property values and investment returns, and drive strategic decision-making in the CRE market. Staying informed and agile in response to these economic indicators is key to navigating the complexities of commercial real estate transactions.
Jeff Carpenter > Partner
As a Partner at SimonCRE, Jeff Carpenter is responsible for identifying opportunities in both ground up development and value-add asset acquisitions. Jeff has delivered successful projects across the country and has been integral to the rapid growth SimonCRE has experienced since joining the firm.