Croot details the current state of inflation and its impact on commercial real estate.

The current inflationary landscape

After 2020, increased demand, supply chain disruptions, energy price spikes and geopolitical conflicts helped drive up inflation, which peaked at 9.1% in 2022. In response, the Federal Reserve raised interest rates 11 times in 2022 and 2023. After three subsequent interest rate cuts in 2024, inflation tempered to 2.7% in November.

The Fed still aims to reach its 2% inflation target, but it isn’t in a rush. Instead, the Fed is taking a wait-and-see approach to the effects of new government policies, supply chains, monetary policies and the state of the global economy. That way, the Fed has more options should we see a shift to high unemployment and slowed economic growth leading to stagflation and a potential recession.

“A more stable rate environment would offer more optimism for commercial real estate. However, elevated treasury yields and uncertainty continue to impact investors, affecting financing, operations and capital investments,” Croot said.

How inflation impacts commercial real estate

Inflation has positive and negative impacts across commercial real estate, including:

• Financing: Debt is typically the largest portion of the capital stack, generally 50% to 65% of the market value of the asset, Croot said. Most loans on stabilized properties span 3 to 10 years. Owners with stabilized properties who secured low interest rates before inflationary pressures pushed rates up benefit from lower borrowing costs. 
• Lease terms: Most commercial lease terms include inflation-linked rent escalations, so income growth keeps pace with inflation. Alternatively, landlords with shorter lease terms can renegotiate rents to reflect current market conditions. Without such protections, property owners’ and operators’ rent growth may lag behind inflation.
• Operating expenses: Materials, labor, insurance, maintenance and other expenses increase alongside inflation. “If that growth outpaces income growth, property owners can experience cost increases faster than rising rental rates,” Croot said. “But when owners can’t pass increased operating costs to renters, net operating income compression reduces cash flow for owners and returns for investors.”
• Property values: “Factors such as weakening economic fundamentals and inflation's impact on renters can negatively affect commercial real estate owners and operators,” Croot said. Though not directly correlated, usually capitalization rates rise with interest rates. “Combined with eroding net operating income and higher borrowing costs, this can negatively impact a property's value,” Croot said.
• New construction: “An inflationary environment may have a positive impact on new construction projects—actual rental rates may exceed pro forma assumptions,” Croot said. That also means it’s more expensive to build new projects, which can limit new construction supply and thus new product competition. Higher materials and construction expenses may also raise existing properties’ replacement cost value.

Inflation’s impact on retail and industrial

The retail and industrial real estate sectors have been commercial real estate’s darlings in recent years. The increased importance of distribution channels and e-commerce helped the industrial sector grow, and retail benefitted from essential retail users and minimal oversupply coming out of the Great Recession, Croot said.

Rising inflation could change that.

• Inflation’s economic impacts can make these sectors more susceptible to consumer behaviors. “As consumer sentiment wanes, retail and industrial real estate and the businesses that operate within them feel the reduction in discretionary spending more acutely,” Croot said.
• Higher operating costs can flatten rent growth. “Some operating costs are passed to the renter,” Croot said. “But there’s a limit to what renters can shoulder in terms of their occupancy costs. If a business’s margins narrow in response to the increased cost of goods sold and other inflationary pressures, the question becomes how high of occupancy costs a business can absorb.” This could flatten rent growth.
• Last-mile logistics properties may see slimmer margins. As rent and other costs rise, including fuel, transportation, inventory management and capital investments, occupants see smaller profit margins. Industrial property owners have also been protected by the lack of developable land in prime infill markets. But current high replacement costs, driven by both construction expenses and elevated land values, make the necessary rents for new developments unsustainable.

How JPMorganChase can help

“While we can’t influence rates, our fixed- and adjustable-rate loan programs with flexible prepayment options can offer borrowers predictability in an unpredictable economic environment,” Croot said. Contact our commercial real estate experts to discuss the best options for your business.