Inflation and How It’s Affecting the Orange County Commercial Real Estate Market

If you haven’t heard, inflation in the United States is on an upward trend. As of March 2022, the Consumer Price Index (CPI) had increased 8.5% year-over-year, the highest inflation rate the U.S. has seen since the early 1980s.

 Although commercial real estate (CRE) is typically seen as a hedge against inflation, markets across the country are still feeling the effects. In this article, we’ll dig into the effects inflation is having specifically on the Orange County CRE market, including:

• Inflation’s impact on landlords

• Inflation’s impact on tenants

• Inflation’s impact on developers

Inflation’s Impact on Landlords

As we mentioned, CRE is typically seen as a hedge against inflation. In fact, a research report conducted by Cushman & Wakefield found that 1% of inflation is associated with a 1.1% increase in total returns. In other words, higher inflation leads to higher property values.

 For landlords in Orange County, these higher property values can have an impact in a variety of ways.

 The most obvious impact of property values increasing is the value of a landlord’s portfolio increasing along with it. If a landlord already owns property in Orange County, they have likely found that the value of the property is higher now than it was in years prior. According to CoStar, the average sale price for class A and B office product in 2022 Q1 was $326/sf, the highest it has been in the data’s history. This is great news for landlords who are interested in selling their properties.

 However, selling a property in Orange County might not be as easy as it once was. The high rate of inflation has prompted the Federal Reserve to increase its target for the federal funds rate by 25 bps, with the expectation being that more raises will follow. This increase in the federal funds rate has appeared to decrease the demand for purchasing CRE product in Orange County. For example, sales volume for class A and B office product in 2022 Q1 was $434.6 million according to CoStar, well below the average of $719 million per quarter over the previous four quarters. Although it may still be too early to definitively say sales volume in Orange County has been significantly hindered as an indirect result of high inflation, the data suggest the market is trending in that direction.

The higher property values brought on by high inflation also have another, less desirable impact for landlords - higher taxes. Higher property values tend to lead to higher taxable values, which means landlords will have to pay up when tax season rolls around. Of course, most CRE landlords pass property taxes through to their tenants in the form of operating expenses, but it is still an undesirable outcome resulting from inflation’s impact.

Inflation’s Impact on Tenants

From a tenant’s perspective, high inflation is having a similar impact on CRE as it’s having on their businesses. High inflation means things simply cost more, and Orange County tenants are beginning to see this come to fruition.

As we mentioned previously, property operating expenses will likely increase and be passed along to tenants in the near term. However, operating expenses only tell half of the story since tenants also have to pay rent for their CRE space. According to CoStar, the average class A and B office asking base rate remains below the pre-pandemic average ($29.48 in 2022 Q1 vs $30.26 in 2019 Q4) but is beginning to see an uptick as inflation starts to replace the pandemic’s impact. The increase may not be significant yet, but Orange County tenants will undoubtedly feel the effect as they sign leases over the coming year.

Unfortunately, inflation's impact on tenants does not end once they’ve signed on the dotted line and successfully leased space. If a tenant needs to build out their space prior to moving in, inflation will play a role in that cost as well.

It’s difficult to say exactly how much impact inflation has had on construction prices so far considering construction costs in the U.S. were 23% higher in 2021 compared to pre-pandemic prices in 2019, but inflation definitely won’t be helping those prices go down. Landlords could potentially assist tenants with these higher costs by offering increased tenant improvement allowances, but tenants will still need to find a balance between building out the space they want and the space they can afford. 

Inflation might not be all bad for tenants though. For tenants who are currently in a long-term lease, there’s a good chance that the lease’s escalations are lower than the current rate of inflation. If that’s the case, those tenants will be able to enjoy a below-market rental rate for the next few years while the inflation issue sorts itself out.

Inflation’s Impact on Developers

Inflation’s impact on CRE developers is a mix of the impacts on landlords and tenants - the upside is higher due to higher property values, but the costs are higher as well.

Land prices in Orange County are on the rise, due both to the effects of inflation and to developers scrambling to secure development sites. Economics would suggest that an increased level of demand paired with a limited supply would lead to higher prices, and that definitely seems to be the case. Even if a developer doesn’t intend to break ground on a new project in the near term, securing the land now could still be cheaper than doing so in the future.

Developers are also having to weigh the risks of higher interest rates in their underwriting decisions. As debt becomes more expensive as a result of the Federal Reserve trying to fight inflation, it becomes less lucrative to pursue the long and capital-intensive process of CRE development. However, developers who are able to lock in a lower interest rate today and successfully deliver their project could potentially experience a higher-than-expected return if property values continue to increase.

All of these impacts could very well culminate in a lower volume of CRE development in Orange County over the coming years. That said, it doesn’t appear that construction has slowed down quite yet. As of this writing, there is still 1.3 million square feet of office development underway in Orange County, which is nearly 700,000 square feet more than was under construction at the end of 2019.

With vacancy rates still sitting above pre-pandemic levels (13% for class A and B office space as of 2022 Q1 according to CoStar) and the cost of construction showing no signs of going down, time will tell if developers hold off on new projects until these challenges can be better addressed.

Conclusion

We hope this article gives you a better understanding of inflation and how it’s affecting the Orange County CRE market. As suspected, inflation will lead to higher costs across the board, but it does offer a few potential benefits as well. It will be interesting to see how the Orange County CRE market changes over the coming year as the impact of inflation continues to be felt.

If you are interested in learning more about investing in commercial real estate, or if you have questions about asset or property management, contact us at [email protected] or 949.668.1110.