As business leaders know, their lease portfolio is their second largest expense after payroll. That cost tends to increase in high-inflation environments because of the specific triggers in rent escalation clauses. These rent escalation clauses are standard in commercial leases: Their function is to protect the values of the leases and ensure that landlords are able to maintain cash flow. Rent escalation clauses function in two main ways: percentage increases or measures tied to the consumer price index.
Percentage increases bump up the rent expense by a specific amount. For instance, if your lease commenced at $45 per square foot with a 2% annual increase, then, in your second year, the cost per square foot would be $45.90. Conversely, the consumer price index ties rent increases to the overall measure of inflation in the economy. During 2022, the consumer price index rose 6.5%, which would push your rent per square foot to $47.93.
These contractual provisions are meant to cover landlords’ increased real estate rental management costs, including rising taxes, insurance, and utility costs. Inflation affects everyone. Yet, as commercial operators know, this cost isn’t limited purely to rent as it disproportionately impacts tenants.
Inflation Drives Up Other Expenses
Besides increased rents, inflation also impacts the total amount of capital and construction costs. With the cost of capital, the purchasing power of $5 is less valuable in inflationary environments than in stable, predictable markets. Examples of this with commercial tenants include rising food costs for restaurateurs and increasing electricity costs across the board.
Construction costs and supply chain logistics are other hurdles. These constraints push construction timelines and diminish the value of newly inked leases. Inflation has sent the costs of steel, wood, metal, and glass through the proverbial roof. In addition, many building supplies are backordered, which delays critical construction jobs and results in project labor shortages.
These expenses tend to be tied to cost inputs, as well as costs of labor, materials, and other macro factors beyond a business’s control. Because real estate expenses are among the most predictable and controllable costs enterprises face, managing and planning for them in business operations should be a priority. To operate in this environment, it’s critical to understand the need for proper tools that provide downside protection and support the business’s mission.
Accurate Real Estate Data Is Key to Protecting Against Inflation
Having your lease portfolio abstracted and the data intuitively organized is critical for your business. Historically, real estate teams have worked in spreadsheets, leaving critical dates, rent expenses, and legal clauses siloed in manual systems. Following that approach in inflationary environments can be disastrous. Not accurately tracking the dozens of data points per lease can be very costly. That threat is even larger for someone who manages multiple office leases or retail sites. Not budgeting for rent escalation, increased utility costs, and common area maintenance costs can quickly demolish budgets.
Instead, businesses need to strongly consider lease management software to avoid those threats. Lease management software is a critical tool for processing lease data and ensuring equal access across all departments, giving everyone a single source of truth to work from. Here are a few key ways lease management software provides protection:
- Financial forecasting. Between rent escalations and consumer price index increases, having a strong pulse on your real estate rent forecast is the first step to understanding where your leasing budget should be allocated. With that baseline, your real estate and strategy teams can search for potential lease liabilities and plan for monthly jumps in payments.
- Lease data reporting. Do you know all your lease expiration dates or which leases have termination clauses? Those two pieces of information alone can help your business let go of a particular lease, expand on a specific space, and provide
cost savings. - Lease accounting compliance. The Financial Accounting Standards Board instituted a new lease accounting guideline called ASC 842. It impacts all private, public, and nonprofit organizations. Organizations need lease management software that manages the entire lease lifecycle, from site selection to critical date management and lease accounting compliance.
Businesses can survive inflation by searching for all cost savings possible, including their lease portfolios. However, that task is only possible with the correct lease management tools. Businesses should be wary of trying to capitalize on those opportunities without the proper software, especially because the stakes are higher than ever. In the long run, it’s important to remember that inflation is a challenging dynamic that can be managed with the right approach, tools, and discipline.
Matt Giffune is a co-founder at Occupier, a lease management software platform helping commercial tenants and brokers manage their real estate footprint and comply with lease accounting standards.
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