Mitigating Inflation Risk in Office Buildings with Gross-lease Structures
Jul 25, 2022, 13:13 PM
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.