Close to one year ago, 12-month inflation numbers began a steep climb into historic territory, reaching levels not seen in 40 years. At the time, analysts optimistically projected that inflation would be transitory– a temporary result of the pandemic and its resulting economic challenges. However, it quickly became apparent that inflationary measures would remain high for at least a year, if not more, and that commercial property would be impacted by the continuing trend of substantial increases in the costs of goods and services.
In December of last year, we looked ahead to 2022 by discussing the potential impact of inflation on commercial real estate, focusing on owners and investors. We followed up in January by outlining the potential impacts of inflation on employers. At that time, analysts were still optimistic that supply chain issues, labor shortages, and high fuel costs would begin to slow by mid-year. However, we’re still continuing to see prices climb, making the cost of living and the cost of doing business higher than many can remember. The 12-month inflation rate reached 9.1% in June of this year. By comparison, the traditional notion of a normal acceptable rate of inflation is a 2% annual increase.
Although banking systems worldwide continue to take measures, including raising interest rates, to manage inflation growth, it’s clear that these economic conditions will be with us for some time. For commercial renters, this ongoing inflation may cause significant ramifications.
Inflation and Commercial Lease Escalations
You can’t turn on the news right now without seeing stories about residential renters who have been priced out of their current homes. With residential leases typically spanning just 12 months, landlords have annual opportunities to raise rents on their tenants. Commercial leases, on the other hand, average five to seven years in length. Because of this, cost escalation for commercial occupiers typically develops slowly and predictably.
Commercial leases typically have built-in rate increases. In some instances, these escalations are tied to the inflation index: As the cost of goods and services increases, so too does the cost of renting that commercial space. However, Cushman & Wakefield economists Rebecca Rodkey and James Bohnaker say that these inflation-based escalations may be the exception and not the rule today: “After decades of inflation stability, many leases have an escalator—a fixed number—based on a historical average of inflation,” they explain. Today, commercial occupiers with fixed escalation rates are benefiting from the current economic environment, as their built-in annual increases are likely much lower than the rate of inflation.
That’s great news for occupiers who are in the early or middle years of their leases. However, lessees whose agreements are coming to an end in the immediate future may have significant challenges keeping their real estate expenses within their current price range. Given the unpredictability of our current economic environment, property owners will be more likely to negotiate leases with inflation-based escalations than they have been in the recent past.
Inflation and Buildout Costs
Tenants leasing new spaces and requiring a buildout should anticipate substantially higher costs in our current economic environment. Prices for construction materials are significantly higher than before the pandemic– in some instances more than double. Compared to February 2020, PVC and plastic piping expenses have increased nearly 130%, aluminum has jumped more than 102%, iron and steel prices have increased nearly 89%, and lumber has jumped almost 50%.
In some markets, lessees may be able to negotiate tenant improvement allowances or even buildout rent exceptions– but typically these are concessions made in soft markets with high vacancy rates. Here in Southwest Florida, our record low vacancy rates have created a distinct advantage for commercial owners. Our local MarketBeats reports show Southwest Florida industrial vacancy at a microscopic 1%, office vacancies at 4.7%, and retail vacancies at 3.8%, all significantly lower than the national vacancy rates of 3.3%, 17.5% and 6.3%, respectively.
While some lessees may consider delaying their buildouts until conditions stabilize, they may be in for a wait. Cushman & Wakefield’s Office Fit-Out Cost Guide notes that 96% of commercial contractors expect supplier costs to increase over the next six months, with the most consequential cost increases anticipated in fixtures, equipment, and furniture.
Inflation and Base Rent
When it comes to base rents, the impact of inflation may be overrated. According to Rodkey and Bohnaker, evidence suggests that market conditions drive rent patterns more significantly than broader inflation. This is good news for tenants in much of the country where vacancy rates remain high. However, Southwest Florida’s remarkably low vacancy rates again are creating a beneficial market for owners rather than for occupiers.
Evidence of this can be seen in our average commercial office rent rates. In Q2 2022, office property was leasing at more than $20/square foot, an increase of 25% in the last two years. However, retail and industrial rents have been growing at a much slower pace over the last eight quarters. Because these two sectors have been hit harder by labor shortages and the increased cost of goods, the market simply may not be able to bear higher rent costs for retail and industrial occupiers.
Navigating Complex Relationships
Our current economic environment is complicated, and unlike in days past, our current inflation issues can’t be pinpointed to a single source. The pandemic, U.S. economic recovery, worldwide supply disruptions, labor force changes, energy prices, and even the war in Ukraine each play a role. As a result, it’s difficult to predict exactly when this uncertain period is likely to end.
Similarly, when it comes to commercial property, inflation is part of a complex economic equation that also involves lease terms, rent prices, vacancy rates, and buildout costs. Our current economic conditions can create both opportunities and challenges for both owners and occupiers. One thing is certain: In our unpredictable economic environment, planning further in advance is more important than ever.
The Commercial Property Experts at Cushman & Wakefield | Commercial Property Southwest Florida have the local knowledge, data, and experience to help you understand the potential risks and rewards of leasing in our current economy. Put our experience to work for you by calling 239-489-3600 or contact-us.