Commercial Real Estate – Inflation Hedge?

With the big spike in oil and food prices in early 2011, its expected that the overall CPI will spike up a bit for 2011 to a level of 2% and maybe slightly higher depending of course on what happens in the Middle East and the resultant affect on oil prices.  I guess this begs the question – is commercial real estate a good hedge against inflation.

If the overall returns of an asset investment exceed the inflation rate then it’s considered a good hedge.  Past studies have concluded that commercial real estate is a good hedge so will that be true again?

Annual returns have begun to rise from the bottom of this downturn in 2009, but as always property categories are recovering at different rates.

With the double dip in residential housing, the multiunit market should do well for the foreseeable future – people have to live somewhere.  Office vacancies have begun to decline and retail has stabilized at a rather high vacancy level of 11%. 

Now, speaking from personal experience, there’s an acute shortage of new/newer single tenant, single parcel, national credit, triple net opportunities available on the market.  This is simply because construction financing was almost impossible to secure over the last three years so there is little new coming out of the ground.   

This has been a particularly difficult problem for me because I represent many California buyers seeking significantly better caps rates by investing out of state.  What they are sacrificing in appreciation rates are more than compensated for by cap rates that are a couple points higher than you find in California.  Problem is that there is little to no inventory and the pipeline is just now starting to ramp up again.   Something good comes on the market and there’s an accepted offer in a few days.  I don’t have to say what that will do to transaction prices.

Prices coming back up will force cap rates downward, however, trends remain divided in many markets.  Trophy properties in major markets are trading at 5% caps and below and secondary and tertiary markets are still in the 8% range or slightly better.

Few investors are counting on high capital returns from trophy properties although what they are getting in return is stable income from a fully occupied building with top quality tenants.  Distressed deals might offer potentially higher rates of income and capital returns, but significantly higher risk so these aren’t the type of deals that we refer to when discussing commercial real estate as an inflation hedge.

“The consensus is that total annual returns from commercial real estate over the next two years will be fairly robust, in the 10 to 11 percent range,” says Reis senior economist Ryan Severino, who serves on the National Council of Real Estate Investment Fiduciaries’ research committee.

“More than half of that [return] will come from income returns as vacancies tighten and rent growth accelerates, but don’t expect big jumps in commercial real estate values,” adds Severino.

Annual returns of 10 to 11% on commercial real estate definitely implies a good hedge against rising prices even if inflation rises significantly from the current expectations of 2%.

Fundamentals still apply of the right property in the right market for the right price.  It’s still real easy to make a mistake.