Living with Inflation: Four Points About Indexation and Office Rents

The precise impact of elevated inflation from an office occupiers’ standpoint depends on many things, not least whether the occupier is able to pass higher costs on to their end customer. And, of course, whether any future cost increases stemming from higher inflation have been planned for with some degree of accuracy.

What is not in doubt, is that it contributes directly to increases in one specific area of the cost sheet – property leases. Most leases in continental Europe are linked, directly or indirectly, to inflation via annual indexation. Put simply, if inflation as measured by Consumer Price Inflation (CPI) is high and rising - as it has been - this will feed directly through to property costs. This sounds unambiguously negative - but it isn’t necessarily the full story. Four points are worth bearing in mind.

1. It isn’t, or shouldn’t be, an unforeseeable cost– indexation dates are set in leases and form a regularly reviewed component of occupiers’ outgoings. That’s not to say that the scale of future increase is easily predictable, but there are useful indications. CBRE’s current economic view suggests that we are at or close to the peak rate of inflation in this cycle, and the Euro area figure for November was a touch lower than October’s number. This represents some good news for occupiers that the worst may have passed - although inflation will remain above-target in 2023 before easing (See figure 1).

Figure 1: Euro Area CPI Growth (%), 2019-25

Source: CBRE Research

Many leases in continental Europe have provision for annual indexation directly to the national CPI, in which cases lease outgoings could be modelled simply by applying the expected rate of change in CPI to the current rent. Most leases in the Netherlands and Spain, for instance, conform to this type although even in the latter some leases are linked to provincial indices.

The suitability of CPI as an anchor for real estate costs has been debated, mainly because it usually contains some elements (food and clothing for instance) which may not be directly relevant to real estate. The composition of national CPI’s themselves vary depending on national patterns of consumption and are usually subject to periodic revision too. For instance, there is current discussion in the Netherlands about the treatment of energy prices in inflation calculations, reflecting a view that the existing process overstates the inflation position in periods of rapidly rising energy prices. On the other hand, CPI is a highly visible and credible measure, and performs similarly to the GDP deflator which aims to capture the price changes of all parts of the economy.

2. Not all leases index fully to CPI in any case, and some don’t at all– in these instances, the rent may be adjusted to apercentageof the national inflation index; or to a completely different index. In France for example indexation is typically to the Indice des Loyers des Activités Tertiaires (ILAT), and in Belgium to the Health Index – these measures generally won’t behave the same as the national CPI. Therefore, it is not the case that simply applying CPI forecasts to the current rent will produce a “correct” profile of future rent liabilities in all cases. However, even in this second category, CPI movements would be at least a reasonable initial guide to indexation adjustments that are actually experienced since all the indices used have some linkage back to overall price movements in the economy.
3. Property typically accounts for a relatively low proportion of overall operational costs– generally less than 10-12%, and less than wages or technology costs. Clearly the impact of inflation on other cost elements needs to be anticipated as well, but in the context of a still-tight labour market and a widespread desire to use corporate real estate as an arm of their talent agenda, corporates should at least consider whether saving on property costs - for instance by moving to cheaper buildings – might be a false economy with unintended consequences, namely making it harder to attract and retain talent.
4. It’s good to talk– the prospect of steep increases in rent costs is leading some occupiers to seek informal mitigation provisions, such as rescheduling or abatement, or to try to switch to shorter leases to take earlier advantage of lower open-market rents on new leases. Even if lease contracts don’t oblige it - and they mostly don’t – some landlords might be prepared to enter into informal dialogue on the topic. After all it isn’t necessarily in the landlords’ interests to enforce all elements strictly, if it risks generating affordability challenges for their tenants. There are indications in some markets that landlords may be willing to waive part of an indexation uplift in exchange for lease extensions.

There are in any case some signs that inflationary pressures may be starting to ease, as interest rate rises take effect, and energy prices and labour markets start to soften. Even so, occupiers are advised to focus hard on assessing the impact of inflation on costs - including in real estate, but across the full range of other cost items as well – and to scenario plan rigorously and early.