Eye Opening Inflation to Hit the Commercial Lease Market in 2022

After the New Year’s midnight toast, retailers and small businesses will have a rude awakening. Their retail or commercial leases are indexed for inflation. 

In November 2021, the annual inflation rate in the US jumped to 6.8%, the highest it’s been since June 1982. 

After many years of taking low inflation for granted, inflation is now front and center in everyone’s minds. At the start of 2021, the U.S. was forecast to end the year with 2% inflation. Instead, it’s dangerously close to 7%. Things like rising demand, wage pressures and supply chain disruptions drive the continued increase.

The challenges brought on by the Covid-19 pandemic, including the dramatic recent rise of inflation, is cause for concern. Many leases are tied up to the 12-month change in the consumer price index (CPI), which is going up sharply, but is forecasted to eventually level out at 6% by mid-2022.

“In the last few years, inflation has been running less than 2%,” said Mark Vitner, senior economist at WellsFargo. “Rents are typically adjusted to the CPI and now they are up to 6.8%. That’s pretty substantial when you’re used to your rent only going up 2% a year, it marks a big change.” 

As inflation is likely to go up 3-5% at least through the rest of the decade, retailers and small businesses are likely to bear the brunt, unless their lease is maturing, and they’ve got other, lower priced options.

“I think it’s the retailers are probably going to get hurt the most,” said Vitner. “I know that some office leases are tied to the CPI, but I think that some small businesses are going to be stuck a little bit there.

“In isolation, the retail environment had been very weak, a lot of retailers were struggling and were giving back space,” said Vitner. “A lot of folks were working from home and moving back to the suburbs. I think that the retailers are going to have to eat this increase in rent, I don’t think they’re going to have a whole lot of alternatives.”

With a lot of people still working remotely, many businesses are consolidating space, which might provide a little more negotiating room for those companies that have office leases that are going up. They might even be able to extend their lease in exchange for better terms. 

According to Vitner, the term “transitory” needs to be retired. While the Fed and the Biden administration have said that higher inflation is “transitory” they may be soon readjusting their perspective.

Those in the real estate industry that are most likely to be negatively affected by inflation include developers faced with the rising costs of construction and supply chain constraints, as well as landlords whose tenants are locked into long term leases that do not account for inflation adjustments.

At some point, the commercial real estate industry will have to conclude that higher inflation is destined to be a long-term issue. However, predicting the future of inflation and its impact on commercial real estate is not so simple.

“The economy doesn’t just grow, it’s kind of slowly evolving,” said Vitner. “And it’s not always pleasant.”