“Inflation” is a growing concern to many people – and rightfully so. To fight back, many investors have been trying ways and means to make their money work harder to outpace rising prices. And there is no straightforward solution, as high inflation has also triggered a chain reaction that saw interest rates rise and economic growth fall – and it has also roiled the already unsettled investment markets. For sure, this has made it an uphill task for many to decide on where to park their funds and grow them meaningfully at a tolerable level of risk.
Some investors are also growing hesitant about investing in real estate, for fear that elevating interest rates may continue to add to rising costs of borrowing and eventually eat into their investment returns.
Do real estate assets benefit from inflation?
Many property investors believe that real estate benefits from inflation, as rents generally get pushed up during inflationary periods. But the truth is, this may not always be the case, especially when borrowing costs and property management expenses are also rising and eating into rental gains.
“Many property investors believe that real estate benefits from inflation, as rents generally get pushed up during inflationary periods. But the truth is, this may not always be the case.”
So, before investing in a property during an inflationary period, it is imperative that you recognise that whether a property will benefit from inflation or not depends on the following factors:
- Lease duration
How long is the lock-in period of the property’s lease?
Are most of the units in the property rented out?
- Repricing power
Is the property able to command or attract higher rents?
- Tenant resilience
Are the tenants able to sail through economic cycles without ending their leases?
- Rent escalation clauses
Do the lease terms take into account rising inflation?
With these in mind, it goes to say that you will have to be selective about which types of properties to invest in during periods of high inflation.
Real estate assets to watch out for during inflationary periods
Speaking of being selective, here’s our take on the types of real estate assets you should adopt a conservative investment approach to, during periods of persistently high inflation:
Properties with long lease durations and fixed rents
An example of such properties would be offices or factory buildings with a lease of five to 10 years, or even longer durations.
While long leases may be a mark of rental security of a property, it can also erode the asset owner’s potential income during high inflation, especially if rents are fixed and the lease covenants were not designed to take into account inflation. In addition, asset owners of such properties would also not be able to rent them to new tenants at a higher rent for an extended period of time, which would limit its repricing ability and income-generating potential.
And of course, as time goes by and wear-and-tear sets in, most owners would want to carry out some form of asset enhancement initiatives to upgrade their properties to net higher future rents. But for properties with long leases, their owners might lack the flexibility to do so to harness the best market opportunities out there.
Properties with low occupancy or less repricing power
Demand and supply decide a property’s rent. And naturally, properties with a low occupancy reflects flat demand, which implies that it could be difficult for asset owners to rake in a higher-than-market-average rent. What this possibly implies is that such properties are also unlikely to command higher rents during periods of high inflation. And until they undergo a great deal of refurbishment, their rental income may succumb to the elevating costs of owning it.Sign Up at RealVantage
Retail properties that largely target the mass affluent customers
Retail is traditionally one of the hardest-hit sectors when consumer prices rise persistently. This is especially so for businesses involving discretionary goods and services the likes of anything from consumer electronics sellers to nail salons.
When inflation is elevated, retail properties with a high concentration of discretionary retail businesses risk lacklustre business performance. This also makes it difficult for owners of these properties to command a higher rent, as businesses may not survive the higher rent and could shutter under the mounting financial pressures.
An example of such properties would be the retail malls that target the mass affluent.
Properties without strong rent escalation clauses and resilient tenants
To protect themselves from the effects of inflation, some owners of some commercial properties will weave rent escalation clauses into their lease agreements. A rent escalation clause is a provision that requires tenants to pay the pro-rata share of increases in building costs, such as real estate taxes, as well as maintenance and operating expenses, as a result of rising inflation over time.
Owners of properties with lease agreements without strong rent escalation clauses or with a cap or collar provisions in rent escalation may find themselves losing out on rental income to compensate for the rising costs during high inflation.
Strong rent escalation clauses help to automatically adjust rents to the pace of inflation with stepped increases in rent, reimburse a larger percentage of tax and operating expenses to the landlords, and could offer landlords flexible options to renew the lease at a higher rent or to replace tenants for higher rents.
In addition to these clauses, it would be another plus if a property has strong anchor tenants the likes of government agencies, established multinational corporations or companies in defensive sectors, which would be able to provide rental security across different economic cycles.
It pays to be selective
While inflation may dampen investment interest in real estate, those who are able to recognise the right types of property to invest in during these challenging times will be able to capitalise on the pockets of opportunity in the real estate market.
“Those who are able to recognise the right types of property to invest in during these challenging times will be able to capitalise on the pockets of opportunity in the real estate market.”
But the devil is in the details. So it will be important that you keep your eyes peeled, dive deep into a real estate project’s specifics, and conduct thorough due diligence, before you take the plunge to make an investment.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.