What Happens to Fixed Rental Rate Increases in an Inflationary Market?

A commonly held theory in the commercial real estate industry has been that inflation can be expected to increase both the value of an asset and the value of the leases related to that asset.  

But what happens when rent increases and the cash flows don’t keep up with inflation?

One answer is that If we see inflation stick around this year, and it is indeed “nontransitory,” the “real return” on an asset will erode over time if the landlord cannot factor appropriate escalation clauses into their rental rate agreements. 

In short-term situations, this cash flow issue can be corrected upon renewals or new leases. But in long-term leases, there is a need to include mutually acceptable language about escalation clauses. This will require meaningful conversations between the tenant and landlord, to make sure everyone is aware of the landlord’s expected return on investment, and the tenant’s forecasts for the future.  

Certainly, inflation can be expected to impact many segments of the commercial real estate market, but long-term net leases are of particular concern. 

Long-term net leases are popular for large capital-intensive assets like data centers, surgery centers, radiation oncology centers and other types of medical offices. These real estate assets with their long-term leases are often sold as investments, with terms that span more than 10 years and have multiple predetermined rent increases.  

The cash flow to an investor from these assets in the long term will not bode so well in an inflationary market unless the lease provides measures to protect the asset’s value from being deteriorated. With this in mind, it’s time to consider various  hedges that haven’t been popular in commercial real estate for over 15-20 years, such as variable indexed rental rate adjustments, which are payments linked to a benchmark interest rate (such as LIBOR) or any index that varies according to the inflation rate. 

In triple net-lease single tenant investments, there has been a transition over the past two decades to a fixed base rental increase. After all, fixed rent increases provide for easy underwriting and forecasting returns, as the rate increase is a predetermined constant. On the other hand, basing increases on CPI, or certain indexed rates, makes for readjustments and settlements of rents each year.

This is an important topic to discuss now because if inflation becomes an ongoing trend, or  “nontransitory,” it’s going to affect how investors view and evaluate proposed purchases. We may see lenders dictating a change in the way landlords design their rent increases, and at the least, expect to see more re-trades as underwriters factor in “real return,” or how the prevailing inflation rate impacts the asset’s ROI. 

We are seeing billions of dollars chasing returns on assets with 1 to 2% rent increases, sometimes with no increases for five years before escalators kick in. But this exposes the investor to inflation cycles, and the 2021 inflation trends are significant. Indeed, there is talk of 2021 ending with an inflation rate north of 7%.  Unless this trend proves to be temporary, any return over a 24-month period will show an erosion in IRR or the “real return,”  and the cascade effect is that it will push up cap rates as underwriters discount properties with fixed low-percentage rental rate increases.  

Even in this tight supply market, there has been talk in the market of investors deciding to pass on deals for assets that have fixed-rate increases on long-term leases, even when the deals involve healthy credit and well-structured leases. This should be of concern to both landlords and investors.

The market is always fluid, but we can expect that cash flow on long-term fixed leases will be negatively affected by inflation unless the landlord can move from fixed to variable indexing for rent increases. And if landlords don’t act, they may see decreases in the asset’s value to investors. With all indicators pointing to continued inflation, it’s time to consider making these changes now.

Juan Vega is executive managing director at Colliers