How to Protect Against Inflation:

A Case for Office REITs and Suburban Investments

Following the pandemic, inflation has risen worldwide, and the United States has seen one of the biggest annual inflation rate increases in decades.

The US Consumer Price Index increased 8.5% for the 12 months ending July 31, 2022, making it the largest increase in 40 years according to the U.S. Bureau of Labor Statistics.

What does this mean for individuals and businesses throughout the nation? It means rising prices are causing capital market disruption and reconsideration of the strategic investment and financial decisions that support long-term financial health. In many cases, it is causing consumers, businesses, and investors alike to re-align themselves to the changing economic and market conditions.

This paper will discuss how suburban office real estate investments might provide protection in a season of higher inflation, lowering the risk and loss typically associated with this economic environment.

This research was assembled for you by the team at The Hartman Companies.

Basic Impact and Outcomes of Inflation

Economically, inflation refers to the rise in the general price of goods and services. When this happens, currency (at its current value) can buy less, which lowers the purchasing power of money.

There is a compounding impact to inflation that leads to concerning outcomes:

Inflation impacts the consumer price index, which means rising costs for food, energy, and commercially available goods.
This is problematic because cost modeling in almost every commercial or retail context relies on price indices and related data.
The result: Forecasting methods are disrupted when inflation becomes severe, making it very difficult for businesses to predict costs and plan accordingly.
Perhaps most important,

rising inflation lowers purchasing power, lowers the value of savings and Treasury notes, and often long-duration assets.

In times when inflation is expected to rise significantly, most businesses and individuals look for recession-resistant investments. One of the most popular options is real estate. Real estate assets are well known for keeping up with inflation and are one of the few investment strategies that may retain value even during fluctuating inflationary periods.

Office REITs as a CRE Investment Strategy

The public’s perception of the arrival and standardization of work from home and hybrid arrangements created operational challenges for owners of office buildings. But the truth is, since early last year, returning to the office has been the more dominant trend.

By mid-2020, as many as 75% of remote employees stated they were eager to return to the office. By early 2022, almost all enterprise-level companies have returned to the office. This includes Netflix, Wells Fargo, and Goldman Sachs as in-office only and Citi, J.P. Morgan, and Amazon offering hybrid options with minimum mandatory in-office hours. While a handful of companies have continued to allow remote-only work arrangements for their employees, many more have now adopted a full or hybrid return to the office.

It’s important to note that it isn’t just enterprise-level businesses returning to the office. Small to midsize tenants are perhaps even more inclined to return, as they rely on collaboration to wear many hats and keep operations moving. Small and midsize companies have tight-knit cultures that benefit from the intimacy of in-person work environments. As company culture continues to be a top priority for the C-suite in businesses of all sizes, office location and the impact of work arrangements on employees is a high-value decision.

Commercial real estate has been remarkably resilient through the past five decades. And even after the 2020 COVID-19 pandemic, it has rebounded and, in some regions, even grown. Top-rated suburban areas — including Austin, Dallas, and Fort Worth — are experiencing explosive growth, which increases the demand for office buildings for businesses of all sizes.

One note of importance can be gleaned from this; commercial real estate investments have historically proven to be an inflation-resistant strategy. These are significant market opportunities that could yield noteworthy returns for commercial real estate investors.

Vacancy Rates

According to researchers, economic conditions, leasing activity, and overall office vacancy rates all signal positively for investing in REITs and suburban offices throughout Texas:

In 2021, leasing activity in Dallas-Fort Worth reached 16 million square feet for the second year in a row; in 2019, at the high point for office leasing activity, Dallas-Fort Worth leased 22.7 square feet.
2021 total sales for office investments in San Antonio surpassed 2020 to reach $588 million square feet. In comparison, pre-pandemic total sales for 2019 were $746 million square feet.
Overall, asking rent has also seen an incremental increase, with a 3.5% year-over-year growth for the last two years.

From Q3 of 2021 to Q1 of 2022, 30 million square feet of office space was absorbed, a dynamic that is holding and is on par with pre-pandemic numbers.

Analysis shows that, while some occupancy challenges persist in primary markets, secondary markets are capturing the attention of office investors. The prediction is that this will quickly drive demand, especially in Austin, San Jose, Dallas, Fort Worth, Houston, Palm Beach, and Nashville.

Supply and Demand

Supply and demand are relevant considerations for buying office properties as an inflation-resistant investment strategy. For example, in regions of Houston, the office market was considerably overbuilt in the 1980s. Some of the development was never adequately absorbed, which resulted in too much supply and not enough demand.

Now that the region is experiencing record-breaking growth, years of leveraging resources to lease-up assets is paying off. For new entrants into CRE investing in this area, the timing has never been better, as demand has never been higher.

Interest Rates

After climbing to a historic peak of 18.63% in October 1981, 30-year fixed-rate mortgages have trended downward. With rates at an all-time low in 2021, what resulted were record transaction volumes in the immediate recovery period after the worst of the 2020 pandemic conditions.

With central bank monetary policy switching gears in 2022, CRE interest rates appear to be increasing, and most economists agree that they will continue in that direction. Policymakers have already signaled a plan for continued hikes during the Federal Reserve meetings of 2022. Target ranges have been raised from 0.25% to 0.5%, which are the first increases of their kind since 2018.

Even with a rebounding economy, uncertainty around interest rates typically results in a slow down of new development and more attention to operating properties. Raw material costs are at an all-time high, not to mention construction labor shortages, making development projects a challenge.

These dynamics force an important conclusion: there is likely less risk and more security in investing in existing real estate assets such as office buildings in the current market rather than pursuing new development.

The public’s perception of the arrival and standardization of work from home and hybrid arrangements created operational challenges for owners of office buildings. But the truth is, since early last year, returning to the office has been the more dominant trend.

Watch: Understanding office investing in 2022

This podcast features David Wheeler and Anthony Trollope of Hartman Capital Markets, which discusses trends and opportunities for office investing in 2022.

Suburban Office vs. Alternative CRE Investments

Real assets have historically been a great inflation hedge. Whether just entering the market or seeking to diversify, you have an array of considerations and CRE investment options.

At Hartman, our strategy is to purchase low-occupancy properties in need of capital improvements and repositioning. For these efforts, we routinely see an increase in occupancy, and subsequent cash flows stabilize after improvements have been made. This is the cornerstone of a value-add investment strategy.

Value-add investing has proven to be a sound strategy for decades, especially in desirable suburban areas close to major metroplexes like Dallas and Houston.

Real estate sponsors are not immune to the ways in which inflation can impact financing, but the possibilities for benefitting from real estate investments during high inflation, especially for suburban offices, are many. Analysis conducted at Cushman & Wakefield finds that

“every 1% increase in inflation is associated with a 1.1% increase in total returns.”

Experts at Deloitte agree that CRE, as an industry, is at an inflection point. One salient point they make is that “Many CRE firms are focusing on retrofitting properties and repurposing spaces for alternate uses to maximize value.” It is widely recommended that investors who invest in real estate sponsors with a long-term view against inflation and for future profits will benefit most from the types of properties where future demand is likely to be high. This includes properties in suburban areas with an array of tech-friendly amenities.

Case for Suburban Office

All of this data and current market understanding coalesce into a winning case for investing in commercial real estate, especially suburban office buildings. Real estate sponsors with these holdings are likely to see encouraging gains in both the near term and long term.

With increasing revenue and physical asset appreciation, real assets have historically responded favorably to inflation. A quantifiable trend of rebound in global trade, passenger travel, office occupancy, and attractive valuations could mean significant inflation protection through investing in commercial real estate.

The case for the suburban office is twofold:

1. There is strong demand from smaller business owner tenants who are looking for amenities, an affordable lease rate, and shorter lease terms.

Here is a quote from the Greater Houston Partnership

“82% of the firms operating in the Houston metro area have fewer than 20 employees. Together, these businesses employ just under 400,000 workers, or about 14% of the regional workforce. . . . Nearly 97% of businesses in the region have fewer than 500 employees— the standard to be considered a small business—and these collectively employ 44% of the region’s workforce, or 1.2 million employees.”

This is the prevalent, fast-growing tenant base in Texas and many other areas, and they want a suburban office.

2. There is a growing call for shorter commute times. This is achieved by working at an office located nearer to home. For most people, that means a suburban office.

Post Pandemic Priorities and Trends

The suburban office is coming out on top in post pandemic priorities and trends. For a start, lengthy, painstaking commutes are a thing of the past in most fields. Even so, it appears that operations will never fully tilt toward remote-only work. Companies of all sizes see the value of in-person collaboration and are having to strike a delicate balance.

Companies want to create an in-person work experience that is “closer to home” and offers the flexibility employees want. This describes the ideal need for suburban offices. It is an option that represents the best of both worlds, supporting the benefits of face-to-face interactions with flexible accommodations for employees.

This is not a temporary issue but a permanent imperative from employees, and employers are diligently trying to provide it to them. It means the demand for suburban office buildings is not going anywhere: it will remain, making it not only an inflation-resistant investment strategy, but a future-proof one.

Additionally, the uncertainty of the country’s economy is creating a dynamic in which businesses sign shorter-term leases than in the past. This can benefit office owners by potentially hedging inflation in the future with the ability to increase rents and renewals based on the market.

Why is Capital Flowing to CRE?

There are numerous catalyzing factors behind capital flowing into commercial real estate.

For instance, one well-known sector for the capital flowing to Texas is the burgeoning technology and life sciences business. Because central Texas has some of the fastest-growing collection of companies in those fields, it stands to gain from enhanced interest.

Another sector responsible for a capital influx into CRE is increased uncertainty in foreign markets. The United States has a reliably strong infrastructure and optimistic economic forecasts. Foreign capital is flowing into CRE in the United States because of this and the fact that other countries are also seeing rising inflation. There are also current geopolitical threats throughout eastern Europe and Asia, making the U.S. a more appealing choice for investors of all kinds.

A last compelling reason is an internal migration within the United States. People are relocating in record-breaking numbers due in part to the disruption of COVID-19, inflation driving up cost of living, supply chain issues spurring a housing shortage in some regions, and more. People are prompted for a variety of reasons to move, and there are new hot spots in the country for this shift, which quickly (and sometimes dramatically) increases the need for office buildings and other commercial spaces.

CRE capital is flowing more freely than in previous years, but it is also important to identify where it is being used.

Where in CRE is Capital Flowing?

As previously mentioned, not all types of commercial real estate are equally valuable when it comes to protecting against the impacts of inflation. There are some current dynamics in various property types that require consideration.

The retail environment continues to shift with the competition of online merchants. Despite that, urban centers are still experiencing high financing activity for retail properties, viewed favorably by lenders in growth markets.
Hospitality is benefitting from resumed business and leisure travel, and hotels in many areas of the country are undertaking renovation projects and planning for growth.
Multifamily real estate also rebounded after 2020, but now shows drastic cap rate compression. Some bought at higher valuations and are now undercapitalized to make improvements and retain tenants. This unwelcome dynamic has generated some wariness among investors and may strengthen the case for buying office properties.
Many investors have historically seen office properties as a “safe harbor,” less susceptible to market volatility, and, in some ways, capable of benefiting from inflation through rent rate increases. Reduced capital availability lowers the competition and barrier to entry for new owners and allows current investors to buy more office properties at a favorable basis.

A Reminder About Market Volatility

The current volatility in public financial markets is a leading reason for the capital flow into CRE.

It is possible to be misled by volatility but skilled investors recognize the probable safety of these types of investments, the prices of which are holding steady, even if transaction volume declines. For example, according to Moody’s Analytics, apartment, office, retail, and industrial sectors have undergone a decreasing transactional trend, but pricing trends hold stable. Analysts at that organization conclude,

“While transaction volumes reflect near-term sentiment, the consistent rise in CRE prices per square foot over the past two decades (with the exception of a small decline during the Great Recession) reflects the long-term demand for income-generating assets.”

How to Prepare for Inflation: Office REITs

Commercial real estate historically has been the best protection against inflation. Office real estate sponsors could be a sound strategy to invest with that may yield returns in most economic climates. Based on current market conditions, rising consumer demand, and a horizon of possibilities, this is the decision some investors are making.

Private equity favors growth when it comes to alternatives. Investing in commercial real estate historically proves to provide a way not only to safeguard against the impacts of rising inflation, but also to create long-term wealth, knowing what we know about what people want today.

The Hartman Companies have owned and operated properties in large Texas markets since 1983. Our expertise and insight are unparalleled, informed not just by research but by real-world experience of owning and operating office buildings. Learn more about our company.