Retail’s Widening Rent Gap

 

It is no secret the commercial real estate (“CRE”) market, and retail, in particular, is cyclical in nature. And while retail’s “boom and bust” cycle has not always been an indicator of overall economic health, historically it would be safe to assume a high-inflation environment would have a swift, negative impact on retail leasing. However, in recent months our economy experienced a new phenomenon in which inflation has reached levels not seen since the early 1980s, and yet other factors such as unemployment remain near record lows, giving mixed sentiment regarding the true overall impact of our current CRE market health. One seemingly constant in recent months; however, is the increased gap in deal negotiation expectations between landlords and tenants.

On one side of the negotiating table landlords are faced with inflated interest rates, supply chain disruption, increased material costs, and of course energy costs are on the rise. So, one compensatory measure that landlords are looking to so they can offset these expenses is higher rents to mitigate the impact of their bottom line. The Federal Reserve announced on September 19th a 75-basis point rate hike; the third such increase since June. According to CBRE’s most recent US Construction Cost Trends report, experts forecast a 14.1% year-over-year increase in construction costs by the end of 2022, compared to a 2-4% historical average. Lead times for key building materials such as drywall and insulation have hit historical highs with respective 600% and even up to 700% longer lead times compared to pre-pandemic levels. Furthermore, the delivery cost of said goods has skyrocketed due largely to ~60% year-over-year gasoline price spike and an American Trucking Association estimated shortage of 80,000 US truck drivers.

However, on the other side of the table, there is an equally strong argument to the contrary. Tenants, whose cost of goods can vary greatly, see an increasing need to keep rent costs low as they project operating costs for new locations. In an economy that has seen accelerated price increases for goods, labor, and many other items, these operators rely heavily on the few remaining fixed expenses they can, with rent being at the top of the list.

Let’s look at this year’s food inflation compared to the national average for the last 25 years. According to the Consumer Price Index, in 2022 the cost of chicken has increased 13.07% year over year, compared to a 2.54% average annual price inflation from 1997 to 2021. Coffee, with an average price inflation of 0.86% year over year from 1997 to 2021, has seen a 12.71% price inflation in 2022. At the same time, tenants are beholden to the same increased construction costs and supply chain delays that are putting pressure on the nation’s landlords. Despite these increases, tenants must also cut costs so they are able to remain competitive in the ever-growing battle for consumers.

As a result, amid one of the most atypical economic periods in our country’s modern history, both parties are forced to make long-term decisions, with unintended and potentially longstanding implications. Landlords are trying to navigate proposals that include increased tenant improvement allowance packages, more stringent CAM cap requirements, and lower base rent, all while simultaneously addressing the aforementioned constraints. At the same time, credit tenants are required to evaluate annual CPI increases, shorter free rent periods, and longer construction schedules amid recession speculation and flattening consumer spending following the discontinuation of stimulus payments that fueled a rapid discretionary spending increase through 2021.

At the end of the day, to overcome these challenges, the saying “It takes two to tango” still rings true (potentially more than ever). It is important for both parties to have a willingness to break from their traditional deal structure and think outside the box to find common ground. From longer lease terms that allow for better amortization schedules to blended tenant improvement packages and in some cases abated rent packages and dynamic rent increases, landlords and tenants must sharpen their pencils to find creative deal structures that allow for both to ultimately succeed, rather than allow a knee-jerk response to dictate the start of a long-term relationship.

At Quantum we have been able to structure deals that are performance-based; as a tenant does better, then more rent can come to the landlord. We have done short-term deals with options to purchase a property and we have even seen a reset in rents based on the cost of borrowing for both parties. The fact remains, we are all in this global economy together!