Inflating Long Term Leases
Daily expenditures grab the majority of inflation headlines. Gas, food, and utilities are easily captured in the data given the frequency of purchase and constant pricing updates. Zoom a little further out and the next most frequent inflation pricing metric is housing. At roughly 40% of CPI composition, it’s less of a factor at first given the delayed reporting. Rents typically reset on an annual basis for most types of housing outside of hotels. Similar to wages, another sticky component of CPI, once housing inflation gets going, it’s a tough one to reverse course unless a recession comes along.
Outside of high frequency price / rent resets, inflation is tougher to handle. Industrial leases, similar to office and retail, fall in the bucket of longer term leases, typically with terms of 3 - 5 years. The norm, before COVID, had always been 3% annual rent increases to capture some kind of rough inflation change. Sometimes it can be less or even zero to accommodate a tenant or finalize a deal.
In today’s inflationary environment, the conversations is finally migrating towards higher annual bumps. Newmark, in a recent report, noted 4% as the national expected average rent increases for industrial properties from 2023 - 2027. A few markets are already at this level. The trend will likely vary by market location and size, with smaller local markets opting for the traditional 3% bumps. The variability comes down to which markets participants (both tenants and landlords) have the awareness or handle the lease volume to capture the fluid nature of rents going higher.
While the difference between 3% and 4% may seem minimal, especially in light of headline inflation trending along at 8%+, it does highlight the inherent challenge of factoring in inflation to future long-term pricing mechanisms like industrial leases. In a year from now, inflation could go back to 2% or continue along at best double digit rates. Yet, as a landlord, you must make the call on these future rent increases in the moment of signing a lease, using current data at hand and gauging a tenant’s willingness to buy off. If the leasing market is strong enough, like it’s been in recent years due to acute inventory shortages, landlords call the shot.
Where annual lease rent increases appear to be falling short in today’s leasing environment is CPI adjustments. While some landlords may try to implement CPI adjustments in today’s leases, tenants push back pretty hard given the uncertainty it causes with their monthly OpEx projections. Left with no choice, I’m sure most tenants would be happy with 4% vs risk of a nearly 10% increase. And, as reminder, CPI adjustments like leverage cuts both ways in the event of lower possible inflation in the years ahead. The statement may seem far-fetched today. Yet, three or more years from now, we could be settling out at much lower rates than we see today. Will it be 2% again? I’m guessing, not. Perhaps, inflation rates more like 3 - 4% as the world structurally adjusts in countless ways to a new paradigm that supports inflation rates much higher than what we saw in the last decade.