LaSalle's November 2022 Macro Indicators

Inflation,   energy and real estate


Inflation has moved rapidly from overlooked to top-of-mind this
year. For the past eight months, many different types of price
movements have received significant attention among economists,
central bankers and real estate owners and occupiers. Global
supply chain bottlenecks and pandemic-related fiscal and monetary
stimulus have all contributed to price instability. More
recently, Russia’s invasion of Ukraine has been a particularly
troubling cause of energy price volatility, especially in Europe.


Many countries are transitioning their energy grids to more
renewable sources, but a full transition could take several
decades. Fossil fuels supply about 77% of the world’s energy,
according to the Environmental and Energy Study Institute (see p.
7). The chaotic collision of inflation and energy shortages –
particularly in Europe – has decision-makers scrambling as winter
approaches.


The disruption of Russian natural gas flows to Europe prompted
delegates of the European Union to discuss solutions and to wean
itself from Russian gas. Some are promoting a common price cap on
all gas imports, while others believe this will limit supply,
further stressing consumers and businesses. As winter approaches,
strategic reserves in Europe are at full storage capacity (see p.
45 Gas Storage), so an immediate crisis has likely been averted.
However, it remains unclear how these reserves will be
replenished once they are depleted. Our analysis of this
rapidly-changing situation in Europe can be found on p. 9 of this
month’s deck.


Energy inflation is also impacting lease agreements between real
estate owners and occupiers. Green Street Advisors recently noted
that on average, energy costs to either the owner or tenant
equals roughly 6% of total rent or USD ~$2.00 psf in both the US
and EU. But with energy costs having risen sharply, the question
becomes: who bears the cost?


In North America, most commercial leases are triple net, with
tenants responsible for utilities, taxes, maintenance, and
insurance. Triple net leases are also prevalent among retail
properties in the US and Canada, but Canada also has gross,
semi-gross or base-year leases which are indexed to CPI
inflation. While tenants pay directly for their energy usage,
owners are not fully off the hook as they bear responsibility for
vacant spaces. Owners can also mitigate cost risk through
guaranteed maximum price contracts for certain utilities.


Leases in the UK are also generally on a net basis. However, to
counter rising prices, tenants have been renegotiating rents
based on total occupancy cost, thus the property owner becomes
responsible for any costs that exceed a threshold. In this
regard, UK tenants have been increasingly seeking different lease
structures that are effectively gross in nature, with shorter
lease terms (see p. 10).


On the European continent, most commercial leases are fully
indexed to inflation annually. Larger retail tenancies such as
grocers often have bargaining power and can negotiate an index
cap or lower indexation levels. But even with indexation, tenants
are becoming more sensitive to utility costs and are negotiating
for increases to be capped. In Japan and China, fixed-term leases
typically put the burden of paying higher utility costs on the
tenant, but landlords must be careful to keep total occupancy
costs under control or a downward reset to the base rent could be
the only way to get a tenant to renew.


Despite progress in transitioning energy grids to renewables in
many countries, the world remains largely dependent on fossil
fuels to provide the power to heat and cool buildings. Rising
energy prices are testing the tenant-landlord relationship and
the balance of power is rapidly shifting in favor of tenants,
especially in weaker sectors like mall retail and offices.