It was the champion boxer Joe Louis who is attributed with the statement, “He can run, but he can’t hide.” “He” is Billy Conn the lightweight challenger to heavyweight champ, Joe Louis. Billy was fast and quick, Louis powerful. In their 1941 match, Louis was behind after twelve rounds, but KO’d Conn in the thirteenth.
Commercial Real Estate is taking it on the chin in this current inflationary market which is hitting below the belt with labor, energy, transportation, materials, and rents.
According to Cushman & Wakefield (June 2022 How Inflation is Impacting CRE Occupiers), labor accounts for 50%-60% of total business costs. Employees are job hopping from one industry to another, relocating from one place to another for a better position, pay, benefits, and a lower cost of living. Employers have countered with wage increases, flexible hours, bonuses, increased benefits, and work from home options, all at a significant cost increase. The Employment Cost Index for the private sector found median wage growth in the first quarter of 2022 rose 6% year over year. Expect another increase in 2023. Labor costs tend to be much like glue and suggest a new normal.
Occupiers are punch drunk with the cost of electricity, heating, and cooling. The U.S. Consumer price index for electricity rose 11% over the previous twelve months ending April 2022. Natural gas rose 22%. Energy costs are generally passed to occupiers.
Transportation and Materials
As a net importer, the U.S. has experienced a supply chain logjam and year over year freight costs ending in April 2022 have increased 24.7% for deep sea freight and 32.5% for trucking transportation costs.
Construction and other materials costs have increased during the pandemic recovery. These costs have increased 13.8% over the last 12 months ending April 2022 and affect the cost of tenant improvements and building construction. They affect office building owners disproportionally as rents are little changed given high vacancy in the market. Supply chain dysfunction and war in Ukraine have exacerbated this problem.
Cushman & Wakefield research suggests real estate costs account for up to 10% of a business’s operating expenses. High level components of an occupiers cost involve base rent, and annual rent escalations.
Occupier demand drives pricing more so than inflation in the office market. Our second quarter office vacancy totaled 17.1 percent which mirrors the rate in 2007 of 16.2% prior to the Great Recession. Louisville’s Class A office asking rate is currently $20.50 PSF compared to $15.98 in 2007. With modest demand and, more importantly, little new construction over fifteen years, inflation plays a limited role.
The influence of new construction and associated higher component costs have been sprinkled in gradually without overwhelming market pricing. Our office rent needle tends to move slowly over time and through inflationary periods.
In contrast, our Louisville industrial market is more dynamic and affected by inflation given the cost of component pieces like concrete, steel, electrical components, roofing materials and more.
Since 2007, industrial vacancy has decreased from a 9% vacancy rate to a 1.5% current rate. During that time, we’ve added 69 MSF of industrial space, an average of 4.6 MSF per year.
In 2007, the average base rental rate was $3.51 PSF. Today, the overall average rate is $5.09, a 39% increase, most of which has taken place since 2015. Nowhere to hide here.
Escalation of Base Rent
Office rent escalations over a lease term, which may approximate five plus years, are three percent or less in most cases, a hedge against inflationary times.
But while pre-pandemic annual rent escalations for industrial occupiers in the Louisville market may have been two to three percent for the last 15 years, increases in 2022 have escalated to three to four percent influenced by the 1.5% vacancy rate.
Poor Billy Conn. Fast as he was, he got too close and was decked by the champ. Commercial Real Estate is no place to hide either and has been taking some powerful punches lately. In the same way Billy could have benefitted with a better plan, it makes sense for business and building owners to consult with qualified real estate professionals to best understand our market and opportunities therein.