Total Occupancy Cost Inflation: Familiar Territory for the Real Estate Industry?


Author: Nick Cliffe

The post Covid world always knew that inflation would return to the global economy. Over two years of recurring lockdowns, compulsory mask wearing and a rapidly changing employment environment led to supply chain disruption, a backlog of demand for goods and services, and a general excitement amongst the public to be free of restrictions.

However, unexpected events in 2022 including the war between Ukraine and Russia, worse-than-expected energy crises and catastrophic mini budgets have considerably exacerbated the inflationary situation. The RPI index in April 2021, as the UK came out of the last significant lockdown, stood at 2.9%; this rose to 12.6% in the space of less than 18 months, an unprecedented rise.

Turning to real estate, these significant figures naturally give rise to an occupier’s consideration of their total cost of their demise. This includes not only their rent, but also service charge, business rates and insurance premiums. This method of reviewing rent in leasing terms has more recently been reserved to the retail sector, whereby the rent paid to the landlord is a percentage of the gross turnover from the store, less the occupational costs. Whilst this is an arguably harder system to implement to offices or industrial units, for example, occupiers are ever more regarding their property level expenditure in this light. The average cost of occupying a new build office has increased by 13% over the 12 months to September 2022, and by 18% when occupying a 20-year-old building (LSH Research).

Whilst open market upwards only rent reviews remain common place in the UK Real Estate market, an increasing number of assets and leases are subject to an index linked rent review. This is a seemingly simple rent review clause that uses the change in CPI or RPI (soon to be replaced by CPIH) indices over a pre-determined period of time to establish the revised rent on the date of review. Real estate is often seen as a hedge against inflation for this very reason. Notwithstanding, there are a number of considerations that need to be given in this context; if the review is annual, occupiers could face a substantial increase in their rental outgoings as the high inflation is set to continue well into 2023; however, if these are five yearly – as tradition would dictate – there may be less of an impact (one would hope) as the forecasts indicate inflation to drop back to slightly ahead of target levels by mid-2024 onwards.

Another element is whether the reviews are capped or uncapped. The latter would indicate that the tenant is exposed to periods of extremely high inflation such as now, clearly benefitting the landlord. A cap, whilst limiting the increases at review for the landlord, provides a factor of protection to the tenant, thereby allowing them to predict and hedge their rental outgoings with more ease.

From a real estate investment perspective, uncapped annual index linked reviews represent the “holy trinity” of rental growth, simply because of the regularity of largely guaranteed upside in income without any loss in real terms. However, it poses an often-overlooked threat that does not materialise until the end of the lease; namely that, if periods of high inflation drive the increases in rental income such that it outpaces open market rental growth, the tenant is paying an extortionate and sometimes unaffordable sum for its real estate and the landlord is left with an over-rented asset, reducing the asset’s investment value as the equivalent yield moves out to reflect the difference.

There is, however, a silver lining to this qualm which can benefit both parties. Negotiating a lower rent for the tenant to pay in exchange for longer a lease term is often the logical and balanced approach. The days are gone where the landlord tries to get the most out of the rent, without due care and attention to alleviating pressure on the tenant’s cash flow for longevity of income. In an eerie replication of rental concession negotiations during the pandemic, partnerships between landlords and tenants and mutual benefits have become the sustainable way to navigate the difficulties posed by the highly inflationary macroeconomic environment and protect the longer-term interests of both parties.

The same principle applies to both the acutely rising energy and construction costs. Whilst adversely affecting all sectors of real estate, this is proving to be a significant factor in the case older, less environmentally efficient buildings. Research from Lambert Smith Hampton has shown that the average annual energy cost increase between September 2021 and September 2022 has registered at 194%, making it a much more significant share of total office cost, whilst fit out costs have increase by 20%. The inflation affecting construction has also slowed development activity, contributing to a shortage of prime, sustainable office spaces and driving a rental premium achieved for green assets as occupiers seek to meet corporate sustainability targets (Savills Research). Operational efficiency can only do so much; landlords and tenants must look for creative and collaborative ways to deal with these obstacles, such as improved and energy efficient building management systems, green lease clauses and price effective retrofitting opportunities, to keep long term operating expenditure to an affordable level.

In summation, the real estate industry has experienced and benefitted from the notion of landlord – occupier relationships very recently during the pandemic and must take valuable lessons from using these during periods of communal hardship. It goes without saying that inflation over the next 12 months will have a significant impact across all parties, but mutual agreements to take longer term views and form partnerships will alleviate some of this pressure and lead to a more sustainable future for the industry.

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