Recently I wrote a post detailing what inflation was and that a hedge fund manager had recommended commercial real estate as a potential hedge against inflation. I realized that I hadn’t explained why commercial real estate acts as a hedge against inflation and a store of value.
Inflation Erodes Purchasing Power
In the previous post I shared that inflation makes money purchase less goods and services. The downside of this is that it can affect the lifestyle of anyone with a fixed income. A set income of $6,000 per month will by fewer services, fewer goods, and less entertainment as prices rise.
How Commercial Real Estate Can Protect Against Inflation
Commercial real estate investments that adjusts with inflation can work to protect the investor against the effects of inflation through income protection and wealth preservation.
Income Protection
The income from commercial real estate is tied to rent. Rent can be adjusted periodically to keep up with inflation.
Rents tied to short term leases, as in apartment properties, are easily adjusted on a regular basis (yearly) to account for the effects of inflation. Self-storage properties are another type of commercial real estate that generally have short term contracts/leases that can be adjusted as inflation takes effect.
As inflation occurs, rents can be increased to track inflation. The increased income can help the investor to maintain the level of lifestyle that they previously enjoyed.
Wealth Preservation
Commercial real estate also works to preserve wealth because it is a hard asset. The nominal price of a piece of real estate will rise as inflation rises.
If the purchasing power of a dollar is cut in half over a period of time, it stands to reason that twice as many dollars will be needed to buy commercial property over that same time period. In this hypothetical situation, the commercial real estate investor has not lost any of their wealth over the inflationary period, because the market value of his building has risen in step with inflation.
Long Term Fixed-Rate Financing
Investment real estate that is prudently leveraged with long term fixed-rate financing has an even greater potential to protect the investor from inflation.
Long term fixed-rate debt provides the investor with the opportunity to buy a larger property than they have the cash for and to maintain a consistent payment until the loan pays off. A fixed-rate protects the borrower from the risks of inflation affecting interest rates and increasing refinancing risk.
The rental income should cover the debt payments for the life of the loan. Each payment reduces the loan amount and increases the owner’s equity in the property, slowly building wealth over time.
If an investor borrows 50% of the purchase price and inflation cuts the purchasing power of a dollar in half over the life of the loan, it stands to reason that the investor’s investment has increased by four times.
For Example:
- Purchase Price =$2,000,000
- Initial Loan = $1,000,000
- Initial Investment = $1,000,000
- Market Value (with inflation) = $4,000,000
- $4,000,000 Market Value/ $1,000,000 Initial Investment = 4x Return On Investment
In Closing…
You can see the benefits that commercial real estate (and investment real estate) offers to protect owners from the effects of inflation. To begin investing in commercial real estate, please feel free to reach out to me at (925) 385-8798.
