Inflation, generally defined as the rise in the price of goods and services, has skyrocketed over the past year. After more than a decade of gradual, 2 to 3 percent annual increases in inflation, the rate has now surged to 8.5 percent. There has been no year-over-year increase this high since the Reagan Administration.
Rising inflation impacts all facets of the economy, including commercial real estate.
As inflation rises, owners and operators of multifamily real estate will want to monitor their portfolio closely. Higher-priced commodities, rising interest rates and other factors can have a substantial impact on the profitability of an asset.
In this article, we explore six strategic considerations for multifamily owners looking to mitigate the impact of rising inflation.
- Carefully consider sales vs. acquisitions.
Typically, rising inflation is correlated with higher interest rates. An environment marked by higher interest rates is generally thought to be riskier which, in theory, could impact the value of real estate. However, not all real estate assets perform equally during inflationary times. Historically, multifamily real estate has outperformed other asset classes, especially during periods of extreme inflation. Economic growth fuels employment and higher wages, which in turn drives demand for housing.
- As interest rates rise and home mortgage rates go up, owning a home becomes more expensive and therefore the own vs rent debate leans towards renting
So while rising inflation will cause some investors to retreat to the sidelines, others will want to view this as an opportunity. This will be a great time for investors to trade up into larger, higher-valued multifamily assets. Those who sell now while CRE prices are still high can utilize tools like the 1031 exchange to scale their portfolios in the months to come—investing the proceeds from that sale at a time when prices are expected to cool off a bit. The flip side of this is that real estate prices could continue to rise as they have done over the past decade, and if owners sell at higher prices with the expectation that they will defer taxes by doing a 1031 exchange into a new investment, new investments at higher yields will be harder to come by and it will likely be impossible to replace the same cashflow.
- Evaluate whether some projects warrant being put on hold.
One of the reasons for skyrocketing inflation is that the costs for both raw materials and skilled labor have risen dramatically. For example, construction material costs were up 17.5 percent year-over-year between 2020 and 2021. According to the U.S. Census Bureau, that’s the largest annual increase in material costs in fifty years.
Owners and operators of multifamily real estate will want to consider whether rising costs means some projects need to be put on hold. A ground-up development project, for example, may now cost more than what the owner will be able to achieve in corresponding rents given local market conditions. Similarly, an operator may decide to put a heavy value-add project on hold until the market tempers, and instead, invest in more strategic, modest property improvements in the meantime.
- Consider whether a change in unit mix can generate higher returns.
In an inflationary environment, owners will want to look for alternative ways to extract value from their multifamily investments. One way to do so is by reconsidering a property’s unit mix. For example, an owner might decide to convert underperforming 3-bedroom units into smaller 1+ bedroom units that generate more revenue on a square foot basis. Similarly, an owner may decide to repurpose 10 percent of the units as short- or mid-term rentals, a strategy that is more operationally intensive but can generate substantially higher returns. A platform like Layers can make the transition from traditional year-long leases to mid-term rentals significantly easier.
- Gain spending visibility.
When faced with rising inflation, there’s no better time for multifamily owners to get a handle on all expenses. Go through all costs with a fine-toothed comb to understand where money is being spent and by whom. Analyze spending by cost category, business process, function and business unit. This ensures that all future spending decisions will be made based on their known impact to the operator’s P&L.
Along these same lines, multifamily owners will want to differentiate between strategic and non-strategic spending. In an inflationary environment, some owners may be quick to cut spending in the short-term without carefully considering the ramifications that will have on the business’s long-term goals and objectives. Any cost-cutting should be done with the company’s strategic goals in mind.
- Take advantage of low-cost debt while you still can.
For nearly a decade, real estate investors have benefitted from the incredibly low-cost interest rate environment. Mortgage rates remained at historic lows during the depths of the COVID-19 pandemic, but things have started to change as we move through 2022. Mortgage interest rates have already climbed more than 100 basis points since the beginning of the year, moving from about 3.5 percent to 4.5 percent today. The Federal Reserve expects to raise short-term interest rates throughout the year, which will make the cost of debt increasingly more expensive moving forward.
Now is the time for multifamily owners and operators to consider their approach to leverage. Look at your portfolio as a whole—how highly levered are you? Are some properties more highly-levered than others? Would a rebalancing of debt be worthwhile?
For those looking to secure additional debt, now is the time to do so. While interest rates have begun to rise, they are still considerably lower than the double-digit interest rates of decades past. Owners will want to lock in low-cost, fixed-rate debt as a hedge against growing inflation moving forward.
Commercial real estate is often considered a strong hedge against inflationary pressures. This is particularly true of multifamily real estate, and especially today, as demand for housing continues to outpace supply. The housing supply/demand imbalance is expected to become more pronounced as inflation rises since rising costs will threaten the pipeline of new construction.
Of course, multifamily investments are by no means foolproof. Owners and operators will want to understand how inflation impacts their portfolios and in turn, make strategic decisions to maximize returns for investors.
Contact us today to learn more about HLC Equity’s approach to real estate investing and asset management during periods of economic disruption.