Owners and Occupiers: The impact of high inflation
This article is part of JLL’s Global Real Estate Outlook 2023
Inflation’s enduring impact
As readers no doubt recognize, we are currently in a period of high inflation. Although its magnitude around the world differs, high inflation over the last year has forced the hand of central banks and now risks compromising the nascent economic expansion of many countries. Yet, inflation looks set to decelerate in the coming years. The supply side of the economy has already shown significant improvement in 2022, helping to alleviate supply-driven inflation. On the demand side, higher interest rates and slower economic growth should help to ease demand-side pressures.
In the U.S., which has raced ahead with an aggressive tightening policy, we see tentative signs that inflation has already started to slow, a potential harbinger for other parts of the world that have also implemented tighter monetary policies. However, even as inflation slows, it could remain elevated relative to pre-pandemic levels. Central banks have shifted their inflation targets towards slightly higher levels, as a pronounced labor shortage in many parts of the world should support somewhat higher wage growth, and the potential for reshoring, nearshoring and redundancy in production could create a more resilient but more expensive supply chain.
In the short term, high inflation has led commercial real estate (CRE) to revisit many established practices. In some locations, the pricing of property management and other service contracts has increased, particularly due to the shortage of workers. And owners are now challenging, if not altering, the structure of leases themselves.
In some areas, like Europe, a few owners have advocated moving away from explicitly including inflation indexes such as the consumer price index (CPI) in leases. The potential also exists for the implementation of cap-and-collar provisions (a clause that limits the extent of changes in rent, up or down relative to market conditions) to insulate from high and low inflation. But in other places, such as the U.S., the reverse is true. Due to relatively benign inflation over the last couple of decades, the CRE industry in the U.S. has largely moved away from including explicit indexes in leases. While some landlords have mooted the idea of bringing indexes back into leases, no definitive progress has occurred. If that is going to happen, it will largely depend on the strength in the market and the ability of landlords to foist that upon tenants. Either way, higher inflation could boost rental increases in leases at a greater rate than recently experienced, even in the absence of such clauses.
However, as inflation subsides in the coming years, that could present risks for a commercial real estate industry that has pivoted to higher inflation. Agreeing to cost increases in multiyear contracts based on current prevailing rates of increase could find landlords overpaying for services in future periods as inflation abates. Some of these costs could get passed on to tenants (depending upon the lease structure), further shouldering them with a heavier load. In some locations, such as Europe, landlords could potentially reap benefits by signing leases now with relatively high inflation embedded into rental rate increases over the life of the lease, but that might leave them with ‘over-rented’ space if the prevailing market rents fail to keep pace with rent increases in existing leases. While that might seem like a boon in the short run due to the somewhat outsized cash flows such leases would generate, it could leave owners with noteworthy re-leasing risk at some point in the future, potentially jeopardizing the value of their property and risking the timing or pricing of a sale. And too much doom and gloom about incorrect expectations of high future inflation could cause a mispricing of CRE assets. While some savvy investors would likely benefit from that development, others would see an adverse impact.
The best course of action would be for the CRE industry to see through the relatively short-term nature of high inflation. Contract negotiations for services or leases should try to reflect this dynamic of relatively high but short-term inflation followed by deceleration and a settling down into a new normal. Any mismatch between actual inflation and what’s expected and embedded in contracts or leases could present problems for both occupiers and owners of CRE. The better the industry can match negotiations and outcomes with reasonable, if imperfect, inflation expectations, and not just reflect current experience, the more efficient outcomes for the CRE industry overall.
Owners of CRE assets should also have rational outlooks for inflation and avoid overreacting to the short-term dynamics. Though admittedly a difficult task, a better alignment of expectations with ultimate reality could help to prevent harmful longer-term damage to the industry from an overreaction to relatively high but relatively brief inflation. The CRE industry benefitted greatly during the 1980s when the last bout of high inflation subsided. As high inflation and interest rates unwound and expectations shifted, the industry performed well. It could be on the precipice of something similar once again.
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