October 11, 2022

Newmark: Nearly All Industrial Occupancy Costs Increasing

In addition to climbing rents, industrial tenants are faced with higher annual lease escalations, operating expenses and utilities as competition for space remains elevated, according to a new report from Newmark.

The total cost to occupy warehouse space has increased 42.2% since 2019. Rent has been the biggest driver, but rent and non-rent expenses alike contributed significantly to the growth.

Acute supply/demand imbalance and increasing construction costs caused rent growth to soar during the past few years, and yet, “for a sector in which tenants are predominantly on triple-net leases, rent growth is only part of the story: nearly all occupancy costs are increasing, not just at lease signature, but over the lifetime of the lease,” Newmark reported.

The current inflationary environment has exacerbated rents and lease escalations, as well as non-rent occupancy costs – operating expenses and utilities.

Annual Escalation Skewing Close to 4%

Pedro Nino, Clarion Partners’ VP of Research & Strategy, tells GlobeSt.com that the spread between high-quality industrial market rent growth and lease escalations has significantly widened across essentially every market that he studied over the past two and a half years.

“The average annual escalation is now skewing closer to 4% in many markets, including non-primary/non-coastal, where 2% to 3% has long been the standard,” Nino said.

“We are also aware of several recent leases achieving annual escalations as high as 6% in markets where recent robust demand has depleted existing occupiable space to essentially zero.

“When considering that Class A industrial rents have expanded by as much as 10% to 25% on average per year after 2019, it makes business sense for tenants to accept higher escalations to secure space and shield from the quickly moving market, and for property owners to seek higher escalations to avoid the potential drag of carrying leases drastically below market.”

Pushing Back Means ‘Deal Doesn’t Get Done’

Robert Poirier, Northmarq Associate Vice President, tells GlobeSt.com that competition for industrial space is at an all-time high, but economic conditions are the primary drivers behind increases in lease escalations and operating expenses.

“In just the past five or six months, we’ve gone from drafting leases with 1.5% escalations to now between 2.5% and 3%,” Poirier said.

“Sellers of sale leasebacks would obviously prefer to keep their escalation costs as low as possible, but they’re finding that pushing back results in a deal not getting done.

“We’re seeing these occupiers come to terms with where the market is, and they’re understanding that due to rampant inflation, investors need to be writing increased escalations into the leases, especially for smaller credit tenants. Investor appetite for higher credit ratings or publicly traded companies may provide more flexibility, but escalations are up across the board.”

Landlords Must Get ‘Creative’ to Reduce Costs

Rene Velasquez, Managing Director of Asset & Property Management, BKM Capital Partners, tells GlobeSt.com that security costs, in addition to inflation, are some of the main drivers for operating expense increases.

“Still, the market fundamentals for the multi-tenant industrial space continues to be strong,” Velasquez said. “To look after their tenants’ financial wellbeing, landlords must get creative in reducing operating costs, and the more proactive ones are managing controllable passthrough expenses to limit the impact to their tenants’ bottom lines.

“Lease escalations will continue to climb due to e-commerce as pent-up demand for small industrial space continues to outpace supply, which should help maintain rental rates and keep vacancies low. Furthermore, construction costs, as a result of supply chain disruptions, will make new construction projects difficult to get under way and keep inventory limited.”