Expenses Will Likely Still Strain NOIs Even When Inflation Subsides

For a moment, forget interest rates. They’ve been higher, they’ve been lower, and they’ll likely drop when the Federal Reserve feels it’s finally won the inflation battle.

But some of the impacts on net operating income that Moody’s Analytics pointed out in some recent research may be more stubborn. Higher prices from inflation likely won’t drop when cost increases from inflation come down to the target 2% annual rate. Insurance prices that have risen due to climate change-driven natural disasters may be up there for good. And those expenses will be something always in the eye of lenders who want to be sure that debt service coverage ratios are in a safe range.

The NOI impact will be most apparent “for certain commercial mortgage-backed securities (CMBS) loans, especially those loans that are already underperforming,” Moody’s writes.

“During the pandemic, commercial properties experienced high inflation for utilities, insurance, labor costs, repairs and maintenance, and property taxes,” the firm continued. “Many of these expenses are related to the supply chain and general inflation and will move with overall national trends.”

However, companies tend not to roll back price hikes unless they feel it necessary from competitive pressure. Otherwise, the higher prices either deliver better gross margins or cover larger expenses and executives are unwilling to part with the greater financial resources once won.

Moody’s says that insurance rates are currently the big punishment to NOI. Over the five years between 2017 and 2022, insurance was up by 73% on CMBS properties. “Five-year insurance inflation was fastest in Nebraska, at 123%, and slowest in Wisconsin, at 58%,” the analyses said. “Outlays for insurance pressure CMBS buildings’ NOI to varying degrees. Insurance is usually 3% to 6% of property net income, but in Texas and Louisiana the share has reached as high as 8% and 9% in 2022, respectively.”

Still, the scary part is that Moody’s says inflation to other operating costs is a bigger NOI risk. “Utility bills, property taxes and other expenses apart from insurance costs are also climbing quickly, and account for a larger portion of property expenses than insurance. Among major expense items, utility costs increased 12% in 2022, compared with insurance growth of 9% and property tax growth of 4%.” Other expenses were up 10% last year. Property taxes rose between 11% and 53%.

“Because property revenue is roughly twice as large as expenses, higher insurance or utility costs on their own are unlikely to cause NOI to decrease substantially if a property’s revenue is performing as underwritten,” the company continued. “If the economy weakens later this year, as called for by Moody’s Macroeconomic Board, then expense inflation will likely significantly exceed revenue inflation, which would decrease office and other property NOIs.”