Inflation: Is it a Good Thing or a Bad Thing for Syndication Investors?

You've seen the headlines: inflation has hit 7.5%. Debates rage about whether it is a long-term trend or just a temporary blip. You hear also that the Federal Reserve is going to raise rates--maybe once, maybe many times this year.

What does this mean for syndication investors in real estate?

We think it can be a positive--if you are working with experienced operators who know how to take advantage of the changing circumstances, not get eaten up by them. That's why the kind of discernment we preach at is so important. The answer to the question really is: IT DEPENDS on whether the operator you are working with knows what to do next.

Inflation does a bunch of things in the case of a syndication. The simplest thing it does is to support increases in rent prices. Every pro forma we have seen--and we mean EVERY one--projects an increase, not a decrease, in rent over time. What's not known is whether the team can deliver those particular projected rent increases. And if they can push those higher rents, what happens then? Can the higher rents be sustained without dropping occupancy?

Recall that two of the ways you make money in a real estate syndication, whether multi-family, self-storage, or mobile homes, is through the monthly cash flow and through increases in the property value over time, which you don't realize until the property is refinanced or sold. With higher rents, it is possible for both the cash flow to be stronger and for the value of the property (which is a function of its Net Operating Income) to rise. That is assuming that the increases in rent do not either cause a big drop in occupancy and assuming that other things don't rise faster than the rents.

What could also rise? Rates for financing and the costs of operating and repairing the building can also rise alongside rents in an inflationary environment. If your project has long-term financing in place, inflation is no problem at all--in fact, for that property, you might welcome the inflation. If your project has a lot of capital expenditures (CapEx) coming due, the costs of those investments could rise quickly with inflation.

So to sum up: If the property is in excellent shape and requires no big CapEx and you have good fixed long-term debt, then the inflation is not only not a bad thing--it might be quite good for your property's profitability. If the property has floating debt that is rising and lots of costs coming down the pike, and if rents can't be pushed too high without dropping occupancy, the inflation could be downright scary.

That brings it all back to the basics. If you have a good experienced operator who has planned for an inflationary period, you could have a terrific inflation hedge on your hands. If you've gone with a rookie operator who got too ambitious when they underwrote the property, it could be problematic. Either way, inflation can matter a lot to your syndication investment.