Slowing Inflation Supports Fixed Cost Small Tenant Growth

Inflation and interest rates are critical factors impacting commercial real estate markets. While inflation has been rising rapidly over the past year, the latest data suggests it may be slowing down. On the other hand, interest rates remain high, with the Federal Reserve signaling a divide that they may increase in the near future. Meaning at the very least, it is likely rates will remain at or near decade highs.  These two factors will significantly impact commercial real estate markets, particularly regarding buildout costs, maintenance costs, and how to price deals moving forward.

WILL SLOWING INFLATION OUTWEIGHT THE RISING COST OF CAPITAL?

The easing of inflation could greatly relieve builders and developers of historically high buildout costs. Especially since the cost of materials and labor for construction has recently risen rapidly due to inflation. However, rising interest rates could maintain high costs of accessing capital, which could offset some of these cost savings. As a consequence, although we don’t predict large commercial real estate transaction costs to rise, their might not be much relief around the corner.

WHAT COMMERCIAL SECTORS BENEFIT MOST?

Inflationary cost reduction is also a critical factor affecting commercial real estate leasing markets. As the rate of inflation slows down, it will become easier for landlords to manage their day-to-day costs. Inflationary cost reductions may result in reduced gross and fixed leasing rates and lower operating costs for their tenants, making smaller and multitenant commercial real estate more attractive as an investment option. The attractive nature of slower inflation is especially true for smaller tenant commercial landlords who operate flex industrial and co-working. The slower inflationary numbers are truly a respite for landlords with fixed gross leases as tenants are increasingly pushing for flexible lease terms and broader application of gross leases in smaller spaces.

Nonetheless, rising interest rates could also offset the inflation rate reduction. Therefore, higher interest will rates continue to increase borrowing costs for buyers and investors, which may result in lower valuations for commercial real estate properties and reduce overall profitability. The cost of borrowing will especially harm landlords who aren’t well-capitalized. However, as interest rates rise, it could lead to an increase in the demand for shorter lease terms and flexibility for owners. This, in turn, for landlords willing to take on more risk could lead to more financial rewards.

WELL-CAPITALIZED LANDLORDS SHOULD BENEFIT FROM SLOWING INFLATION

In conclusion, slowing inflation data combined with rising interest rates will significantly impact commercial real estate markets. While easing inflation could provide some relief to builders and developers, it could be offset by higher borrowing costs due to rising interest rates. Nevertheless, as the rate of inflation slows, it will likely become easier for businesses to manage their costs, making commercial real estate more attractive as a predictable investment option. However, investors and occupiers need to be mindful of these changes and adjust their strategies accordingly to maximize their returns.

If you’re seeking to better understand the complexities of the current real estate market, our commercial real estate agents would be happy to help you evaluate your options and find the best fit.