Strategies To Hedge Inflation On The Rise As Rates Reach Into The Stratosphere

Commercial real estate has historically been viewed as a safe investment during times of inflation, but industry players are going the extra mile to protect their assets as rates reach historic highs.

Annual inflation landed at 6.8% in November, the highest rate since 1982, according to the U.S. Bureau of Labor Statistics. Opinions vary on when relief could be coming from the Federal Reserve, but in the meantime, new strategies have emerged to hedge price increases.

“The pace of inflation and the pace at which it is increasing is creating new dynamics in the marketplace,” said Coler Yoakam, senior managing director and net lease platform co-leader for JLL Capital Markets. 

Building rent growth into long-term leases is still one of the most practical ways to soften the blow of rising costs. Doug Prickett, senior managing director for research and investment analytics at Transwestern, said this could become more common in an inflationary environment and when market fundamentals allow.

“On the rent side, putting in some nice escalation clauses that are tied to [the consumer price index] hasn’t really been that relevant for a while, but it’s going to be absolutely relevant today,” he said. “It’s a great way to protect yourself … on the asset types that are more vulnerable to [inflation] and have longer lease durations.”

Built-in rent escalations of between 2.5% and 3% are not uncommon for longer-term industrial leases in Texas, said Fred Ragsdale, an associate with JLL’s Dallas Industrial Services group. But as inflation reaches a 39-year-high, some property owners are pushing for annual escalation rates as high as 4%, he said.

“Nobody is batting an eye when you see that on a proposal,” Ragsdale said. “One of the reasons you are seeing the lower cap rates is because people are pushing the escalations more aggressively for a better cash flow down the road.” 

During periods of high inflation, money tends to flow into property types with rents that adjust on a frequent basis, such as multifamily, hotel or self-storage properties, said Joseph Iacono, CEO and managing partner at Crescit Capital Strategies. These types of assets can be viewed as lower risk when constructing investment portfolios, he said.

“If you’re concerned about long-term inflation, you probably want to stick to assets that have adjustable rent structures that can offset inflation as it’s happening,” he said.

Apartments and industrial products are leading investments during times of high inflation, said Robert Gutierrez, director of research at Berkadia. According to a 2022 forecast report from CBRE, investment volume in both areas is projected to exceed 2021 levels by 10% to 15%.

“Apartments have favorable inflation sensitivity, meaning returns tend to rise with rising inflation. The same goes for industrial,” he told Bisnow. “In a high-level qualitative sense, both property types are more necessity-driven — people need a place to live, and the world needs facilities to produce goods and products.”

Many investment firms are now structuring shorter-term leases for office and industrial properties as well, Prickett said. Some are going even further and employing expense stops and caps on controllables, which govern how much of the maintenance, insurance and tax cost increases the landlord will cover, he said. 

A trend that has surfaced in recent months, Yoakam said, is that some investors, particularly those in the industrial space, are preferring to purchase properties with vacancies rather than those that have tenants bound to contractual rents with escalators as a means of taking advantage of fast-rising rents. 

“Letting that rent run a little bit before signing leases is actually where people pay more on a price-per pound for vacancies than they would for an in-place lease,” he said. “That’s just a dynamic we really hadn’t seen before.”

Heightened demand and lack of available space continued to press industrial vacancy rates into record lows in 2021, according to JLL. As of Q3 2021, the national vacancy average was 4.3%, and annualized rent growth had reached 7.1%. The average rental rate was $6.76 per SF, per JLL.

One mechanism lenders are using to protect against the surge in inflation is issuing shorter-term floating rate loans, said Shaunak Tana, head of structured investments for Basis Investment Group. The surge in collateralized loan obligations, or CLOs, reflects lenders’ desire for shorter duration loans, he said.

“Having loans indexed to a rate that will tend to have a positive correlation to inflation is a good way for lenders to protect against inflation,” Tana said in an email.

The number of CLOs issued in the U.S. reached an all-time high of $133B for new issuances by the third quarter of 2021, an increase of 116% year-over-year, according to an October report from Voya Investment Management.

A final caveat investors should consider when building their portfolios is where rates will be upon their exit, Crescit Capital Strategies' Iacono said. The Federal Reserve has indicated it could raise rates three times this year, but how significant those adjustments will be remains to be seen. 

CBRE’s 2022 forecast report predicts that inflation will remain well above the Fed’s 2% target through the first half of this year, but should not exceed 2.5% as issues around the supply chain and other economic headwinds ease.

“Underwriting into a rising rate environment is difficult because of the need to predict how cap rates will look and the impact that has on terminal value,” Iocano said. “Some reasonable rise in interest rates should be able to be absorbed. I certainly wouldn’t be underwriting my terminal value based upon interest rates that are indicative of today … but I don’t think we are going back to 1975. There’s a lot of room in between.”