- Inflation is defined as the general rise in the price of goods and services over time, resulting in the sustained drop in the purchasing power of money.
- In the world of investing, inflation is an important concept when considering returns. If the return isn’t outpacing inflation, the investor is losing money in real terms.
- In an inflationary environment, ownership of “hard” or “tangible” assets can be an effective way to hedge against rising prices. Commercial real estate is one such asset.
- As prices rise in an inflationary environment, so do rental prices for real estate, which in turn drive Net Operating Income and property values higher.
- There are three ways to invest in commercial real estate: directly, with a REIT, or through a private equity firm.
A commercial real estate investment can provide many benefits including income, capital gains, favorable tax treatment, portfolio diversification, and inflation protection. Most of these benefits are fairly straightforward, but the last one—inflation protection—is commonly misunderstood and often overlooked. In order to understand what it is and why it can be powerful, it is first important to understand the concept of inflation itself.
What is Inflation?
Inflation is the general rise in the price of goods and services over time, resulting in a sustained drop in the purchasing power of money. In other words, a dollar today is worth more than a dollar in the future due to its loss of purchasing power.
With any type of investment, inflation is an important concept because returns need to be measured both in absolute terms and in relative terms. For example, an individual could allocate money to an investment that pays an interest rate of 3% annually (the absolute return), but if inflation causes consumer prices to rise by 3% in that same year, the relative return on the investment is 0% because the purchasing power of that capital remains unchanged. In that way, it is important for an investment to earn a return, but it is more important that the return outpaces inflation to ensure that purchasing power increases over time.
While inflation can seem scary, many experts and economists actually consider a small amount of it to be a sign of a healthy economy. This is because it encourages consumers to spend money today rather than save it and watch its purchasing power erode over time. In fact, the United States Federal Reserve (as well as other central banks around the world) monitors inflation closely using the “Consumer Price Index” or “CPI” to ensure that it stays within a desired range of 2% – 3% annually. If the economy heats up with prices rising too quickly, the Fed will raise interest rates to slow it down. Conversely, if economic growth is contracting, the Fed will decrease interest rates to encourage economic activity.
Given the known effects of inflation, it is only natural for investors to ask which asset classes or investment types perform well in an inflationary environment. In other words, which investments can best serve as an inflation hedge?
How Commercial Properties Serve as a Hedge Against Inflation
Generally, in an inflationary environment, the best assets to own are “hard” assets like commodities (gold) and real estate because their prices tend to rise in tandem with inflation.
Returns from a commercial real estate investment come from two places—income and capital appreciation—which work in tandem to combat inflation trends. The easiest way to illustrate this concept is with an example. Suppose a real estate developer is considering the construction of a new industrial property. As part of the project analysis, the developer creates a budget estimate for construction costs and a proforma financial projection for potential income and operating expenses. If construction costs are rising faster than rent prices, as they do in an inflationary environment, then the developer will not be able to achieve the desired return, and it’s likely he or she will ultimately scrap the project.
If the developer does walk away from said project, there will be one less industrial property on the market—and with limited supply and strong demand, rental prices for existing industrial properties will rise. These rent increases generate higher net income, which in turn drives property values higher, generally outpacing inflation over time. For this reason, commercial real estate assets, regardless of property type, are a good hedge against rising prices driven by inflation.
How to Invest in Commercial Real Estate
For those convinced of the inflation-hedging powers of commercial real estate, there are three potential ways to invest in it:
(1) Directly: Individuals with the time and expertise needed to operate a commercial property can form an LLC and purchase a property directly. This strategy necessitates that the investor be actively involved in the property identification, selection, financing, and management processes. While this approach can offer significant benefits to those with the time and operational expertise needed to be effective, it may not be the best fit for individuals looking for passive investment options.
(2) REITs: A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, providing access to the rental income and profits produced by the underlying assets. REITs can be publicly traded, which allows investors to buy and sell shares like stocks or mutual funds, providing a high degree of liquidity. Alternatively, they can be private, which provides less liquidity, higher management fees, and a longer-term commitment.
Generally, passive commercial real estate investors who prefer the REIT structure can choose from one of four types:
- Equity REITs: Equity REITs are publicly traded companies that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs fall into this category and are considered attractive because of their liquidity and high dividend yields.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on the loans and/or dividends from security investments.
- Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
- Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles, or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.
Given the number of REIT categories, there are enough options to meet the needs of nearly all investors. However, one of the major drawbacks to investing in a REIT is that an individual has little to no say as to how or where their capital is deployed. They simply contribute funds to a “pool,” and it is up to the asset manager to choose the properties and/or loans for investment. For those individuals who want to know exactly what they are investing in, a private equity commercial real estate investment may be a better fit for their objectives.
(3) Private Equity: Private Equity Real Estate firms and REITs have a similar mandate—to pool investor money and deploy it into real estate assets in order to produce passive income. However, the securities offered by Private Equity Real Estate firms are not publicly traded and are only available to accredited investors.
A private equity investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires significant experience, and private equity real estate firms specialize in these areas. This deep expertise allows the manager to keep a close eye on key operational metrics, such as leasing activity, Net Operating Income (NOI), vacancy rates, operating expenses, and real estate taxes.
- Diversification: There is a strong case to be made that commercial real estate investing can provide an added element of diversification in the traditional stock/bond portfolio.
- Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner, allowing investors to reduce taxable income through depreciation.
- Flexibility: Because they aren’t heavily regulated, private equity firms can be flexible in their investment strategy, giving them the freedom to pursue profitable deals in whatever real estate market makes sense. For example, they could pursue a commercial residential property in one deal followed by an apartment building in the next.
- Incentive Alignment: Because private equity firms are also invested in their own deals, their incentives align with those of the investor in that they both want a profitable outcome.
- Exit Plan: Private Equity Real Estate firms enter an investment with the exit and desired cap rate in mind, which provides investors and lenders with a roadmap to a successful outcome.
- Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
No matter the preferred option, an investor can gain exposure to commercial real assets and enjoy the inflation protection that tends to come along with them.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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