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Inflation's Impact on Office Occupiers

 

This is part two of our series on How Inflation is Impacting CRE Occupiers, in which we explore the impact of inflation on specific occupier sectors. Alternatively, follow the links for insights on the impact of inflation on industrial and retail.

Office occupiers may have had it “easier” on the inflation front since, largely being service providers, price increases have been less broad in scope and severe in nature. But they are experiencing no shortage of challenges as they adapt to work-from-anywhere and intense competition for talent that now has fewer city-edge borders. Companies are also struggling to commit to new pay models for remote-first or mainly-remote workers who can potentially have a much lower cost-of-living than non-remote workers in similar roles. Office occupiers dedicate anywhere from around 30% to 70% of operating expenses to labor, and much of their value is derived from intangible assets (i.e., knowledge and intellectual property), making today’s task of attracting and retaining talent amidst the Great Resignation even more vital. 

Value Composition of S&P 500 


Cost Implications of Talent and Goods  
Of course, there are pros and cons of a more distributed workforce when it comes to cost implications for companies. Wages are rising across the board, but finance and business services industries are seeing below-average wage growth at 5% year-over-year (in April 2022) according to the Federal Reserve Bank of Atlanta, whose wage tracker is viewed as a gold standard. Overall wage growth for all sectors is 6% year-over-year. We have seen some examples, especially in high finance, of significant pay increases, but the impact on headline figures for office-using sectors has been muted thus far. Moreover, in today’s environment, employers are having to factor in benefits of flexible working as an additional and necessary perk to attract the best of the best. Even though companies have been reticent to announce official policies around compensation for similar roles across markets with highly varied costs of living, the reality is that hiring in a variety of locations with different labor costs provides an opportunity for firms to compete for talent (and provide higher wages) while still mitigating the overall effect in operating expenses. That is, if a company that was previously 100% located in a high-cost city now employs 10% of its labor in lower-cost markets, it can not only offer those 10% higher wages than they currently receive, but they can also possibly lower the company’s total cost associated with payroll. This theoretical example highlights the complex environment in which companies find themselves and the variety of factors that could influence their bottom line. 

Relative to goods inflation and overall inflation—and outside of labor—the pace of price increases directly impacting or emanating from office-specific sectors that mainly provide services (at least services unrelated to transportation and warehousing) is limited. The following data supports that reality.   

  • Producer Price Index (PPI) inflation has only crept up by 3.3% year-over-year versus 16.3% for firms producing goods. 

  • Consumer Price Index (CPI) indices for IT hardware/software and information processing are down 0.9% and 0.2% year-over-year in April 2022. 

  • CPI indices for financial and legal services are up 6.9% and 6.5% respectively over that same period.  

A Window of Opportunity  
About 80% of office inventory is occupied by renting tenants, meaning that only about 20% of inventory is owner-occupied. Real estate markets have provided a window of opportunity for many companies who have needed more space or have had leases roll since the pandemic. The U.S. office market—although seeing some green shoots like accelerated leasing and stabilizing sublease volumes—remains the only major sector in a correction, recording slowing but negative absorption as of Q1 2022 with national effective rents down about 12.5% since Q4 2019. The dynamics for occupiers are contextual:  

  1. The best product is performing very well, commanding bidding wars and with high occupancy rates  
  2. Lower-quality, less well-located product is the weakest.  

Markets with limited supply, high in-migration and rapidly recovering office labor markets have also been leaders. Thus, depending upon the type of space a tenant needs and where that space is located, the tenant may be confronted with highly bifurcated market conditions. Many markets (four-fifths of those surveyed in April 2022) consider overall conditions to be moderately or extremely tenant-friendly, though. 

Current Market Conditions 


Further, many occupiers remain unsure about future office needs. This has not prevented some firms from pursuing strategies that require less square footage per worker, and/or square footage that is also designed differently. It may even be the case that such firms have increased their total square footage even if space requirements declined on a per worker basis. In some instances, companies may downsize but increase their rent per square foot as they upgrade into office space that serves multiple purposes, with emphasis on attracting employees back to the office, collaborating, bonding, and providing an experience with hints of hospitality. A benefit of remote work means that real estate costs may also become more distributed, with expansions in lower cost markets or through flexible office in locations where only a small pool of workers live. For many companies, this is not a substitute but a complement to locations in larger cities where deep pools of talent remain. Lastly, occupiers should prepare for the inevitable improvement in market conditions as vacancy rates peak and rents bottom in 2022-2023. In other words, the window of opportunity will not last forever. But for now, there is no question that office occupiers have been the least hit by today’s inflationary environment. 

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