Mitigating Inflation Risk in Office Buildings with Gross-lease Structures

Executive Summary:

In the current environment of a historically tight labor market and elevated inflation, operating expenses (OpEx) are coming under intense scrutiny. This has significant implications for lease structures and valuations.

• A CBRE analysis of the relationship between gross and net asking rents over time suggests the spread is driven by changes to operating expenses and inflation expectations.
• More than 95% of movement in OpEx is explained by lagged changes in the Consumer Price Index (CPI) (R-squared .95), with a 1% increase in CPI generally driving a 1.3% increase in operating expenses (OpEx) one year later.
• Our findings suggest the spread between gross and net rents includes a premium paid to landlords for taking on inflation risk related to operating expenses. A 1% change in operating expenses is generally associated with a 1.48% change in the gross-net spread.
• The current inflationary environment will likely drive higher gross rents to account for expected increases in OpEx and more landlords quoting net rents so as to lessen the “sticker shock” effect of higher gross rents.
• We expect to see more leases structured with a service charge tied to operating costs and CPI-adjusted escalations. This is a common structure in Europe, though it could deprive landlords of a premium associated with taking on OpEx and inflation risk.
• OpEx increases are expected to erode 2.4% of value, on average, for full-service-gross leased U.S. office buildings in 2022.

Introduction:

While there are many permutations, U.S. office leases are typically structured as ‘gross’ or ‘net’. Gross leases often require the landlord to fund OpEx increases. The responsibility falls on the tenant in net leases.

Most U.S. office leases are gross leases. In the low inflation environment of the past decade, the risk associated with covering current and future operating expenses was perceived as minimal. However, the past year has revitalized the importance of accurately quantifying financial risks related to inflation and OpEx.

Landlords often limit their inflation and OpEx risk. The ‘expense stop’­—a negotiated clause common in U.S. gross office leases—determines the point at which a landlord is no longer responsible for paying OpEx increases. Alternatively, some landlords will pass these increases directly to tenants but provide a ‘cap’ after which point the landlord assumes responsibility for overages.

In the low inflation environment of the past decade, many landlords opted for fixed escalations, offering tenants certainty in expenses while benefiting from escalations that outpace expense growth. As each of these structures expose landlords to some inflation risk (with un-capped risk in the fixed-escalation model), this article analyzes the magnitude of exposure borne by landlords with gross leases, with a focus on the fixed escalation model that has become more common in recent years.

Methodology:

Identifying the drivers of OpEx and the spread between net and gross leases will help us quantify how exposed gross lease structures with fixed escalations are to above-expectation increases in operating expenses. In theory, this spread consists of OpEx and a premium paid to the landlord in exchange for holding inflation risk tied to OpEx.

We used statistical modeling to forecast operating expenses and the ‘gross-up factor’ to identify the drivers and magnitude of risk to conclude how much exposure landlords face when inflation rises above expectations. We’ll touch on what the changing inflationary environment might mean for landlord decisions in the short-term. And lastly, we identify evidence-based strategies for mitigating inflation risk in the future.

Quantifying the risk and premium to landlords for holding OpEx and inflation risk

Identifying the drivers of OpEx:
Leveraging data from the National Council of Real Estate Investment Fiduciaries (NCREIF) on aggregated building-level OpEx, along with data from the Bureau of Labor Statistics (BLS), we’ve found more than 95% of movement in OpEx is explained by lagged changes in the Consumer Price Index (CPI) (R-squared .95), with a 1% increase in CPI generally driving a 1.3% increase in operating expenses one year later.

FIGURE 1: CPI vs NCREIF Operating Expenses

Modeling the Gross-Net Spread:

A CBRE analysis of the spread between gross and net asking rents and the change in that spread over time suggests that the spread is driven by changes to OpEx and to expectations of future inflation, as modeled by the Federal Reserve Bank of Cleveland (leveraging data on treasury yields, inflation, inflation swaps and survey measures).

Importantly, our findings suggest this spread includes a premium paid to landlords for taking on inflation risk related to OpEx. Regressing changes to this spread against changes to operating expenses and inflation expectations leads to the conclusion that, holding all else constant, a 1% change in OpEx is generally associated with a 1.48% change in the gross-net spread, while a 1% increase in one-year-out inflation expectations affects a 0.25% increase in the spread. If there were no premium for operating expense risk, we would expect to see a one-to-one ratio on the impact of operating expenses on this spread. This is noteworthy because while landlords have tools to account for inflation, the data show they are generally being compensated for the risk that those tools can be insufficient.

FIGURE 2: Y-o-Y Change in OpEx (NCREIF) vs N & G spread

Net asking rents have remained steady during the sample period, with a standard deviation less than half that of gross asking rents. As such, gross rents have driven nearly all of the changes to this spread. Large swings in gross asking rents around the dot-com downturn and the Global Financial Crisis likely speak to expectations of growth that was abruptly re-priced amid a sharp economic downturn. The past decade of relatively stable inflation and economic growth offers a more consistent time series, allowing for a clearer visualization of the premium paid to landlords holding gross leases. What can get lost in the consistency of the past decade is that this additional return is not without risk.

FIGURE 3: Y-o-Y Change in OpEx (NCREIF) vs N & G spread since 2012

Quantifying Risk & Loss:

Landlords face challenges with fixed-escalation leases when OpEx increases are abnormally high or unforeseen. Given underwritten OpEx increases likely assumed a continuation of the consistent trend from the past decade, current and forecasted inflation is expected to put downward pressure on net operating income (NOI) growth. This is especially true of leases signed in 2020 and early 2021 when the gross premium was declining as inflation was relatively muted at the onset of the pandemic and expense escalation was expected to remain mild-to-nonexistent. While that risk premium for a lease signed in early 2020 would absorb some of the OpEx inflation now expected in the coming years, landlords and investors likely relied on that income to meet aggressive underwriting in this low cap rate environment.

Using the above modeled analysis to predict changes to OpEx, we can quantify the impact of inflation on OpEx, and subsequently the reduction in NOI growth at $0.71 per sq. ft., on average, for the average U.S. office building in 2022. Using the national average gross asking rent of $36.83 per sq. ft. as a proxy for in-place rents, the predicted impact of inflation on NOI growth for a fully gross-leased building would be -2.4% in 2022. Assuming an average U.S. office cap rate of 5.5%, the relative value lost to this hypothetical building because of above-expected inflation would be $12.89 per sq. ft. For a 100,000-sq.-ft. office building with fixed escalations, that’s roughly $1.3 million in eroded value.

FIGURE 4:

There is also a relationship between the gross/net spread and the number of buildings quoting net versus gross rents. As both metrics are a good representation of perceived inflation risk in holding gross leases, they tend to move in the same direction. It is, therefore, reasonable to assume that the current inflationary environment will drive not only an increase in gross rents to account for expected increases in OpEx, but also an increase in buildings quoting net instead of gross rents. The former represents the re-pricing of OpEx risk, and the latter represents those unable or unwilling to stomach this re-priced OpEx risk.

FIGURE 5: Gross-Net-Spread vs Count of Buildings Quoting Net v Gross

Landlords who opt for net lease structures are not entirely insulated either. Long-term net leases with fixed escalations could underperform the broader market if escalations are tied to old expectations of inflation. 

Expectations for short-term changes:

 Along with the expectations that the gross/net spread will grow in the coming quarters to account for OpEx and inflation risk, we also expect to see more and more buildings quoting net instead of gross rents. Anecdotal evidence suggests we are likely to see more modified gross lease structures, particularly impacting how annual escalations are calculated. We expect to see more leases that include a service charge tied to operating costs and CPI-adjusted escalations—as is common in Europe—though this could deprive landlords of the premium for taking on OpEx and inflation risk. It is likely that landlords who were aware of the risk associated with that premium will continue to bear that risk, while those who were less aware of the risk they were implicitly taking might be more prone to shift to net lease structures, or a more modified gross structure, especially given the uncertain short-term future of inflation and operating expenses. While continued uncertainty in the coming quarters would presumably put upward pressure on that premium (more risk = more reward), macro factors around the changing composition of office demand could offset that pricing pressure, particularly among commoditized office buildings. This could mean those commodity assets would make up the bulk of shifts toward net lease structures.

Impact on future strategies:

U.S. office leases tend to do a great job ‘hedging’ against expected inflation. Often overlooked is the fact that office buildings are quite susceptible to unexpected inflation given the long-term nature of U.S. office leases. There are, however, strategies that can be undertaken to better insulate properties and investors from inflation risk.

• Staggered Rent Rolls: Many real estate investors understand the value of staggered rent rolls as it relates to roll-over risk and financial stability. Another benefit of the staggered lease roll is the ability to mitigate exposure to changes in the inflationary environment by periodically re-marking-to-market expectations of inflation and OpEx.
• Modified Gross Leases: As stated above, it is likely that the elevated inflation of the past year will increase preference for leases with CPI benchmarking that determine future rent escalations. While the adoption of this strategy would be hard to quantify given the lack of transparency around leases, we could look for indicators of this trend via anecdotal or survey evidence. And we can monitor the portion of the gross/net spread attributable to this risk premium to determine if it is shrinking as inflation risk in gross leases is pushed onto tenants.
• Increasing Risk Premium: Landlords receive a quantifiable risk premium in exchange for taking on OpEx and inflation risk. As is so often the case when times are good, that premium closely resembles arbitrage. Changes to the inflation regime (at least in the short term) have reminded landlords that this premium is, in fact, in exchange for risk. Given the uncertainty around how long elevated inflation will persist, we expect this risk premium to increase. If upward pricing (because of that premium) conflicts with broader trends in office demand, we could see more buildings listing availabilities on a net basis.

Conclusion

While this article provides a theoretical framework for understanding inflationary OpEx risk of gross leased buildings, it is not meant to broadly dictate the nominal impact of inflation on building NOIs and valuations. CBRE Econometric Advisors has performed such analysis, though, which can be found here. This paper attempts to shed light on the magnitude of exposure to above-expectation expenses in times when inflation surpasses underwritten levels and identify strategies to mitigate that exposure, or at least, accurately price the risk. The overarching fact remains that the premium received for holding gross leases is never without risk. Said bluntly, there is no such thing as a free lunch.