Jan 17

Inflation Deflation

Inflationary pressures are altering the retail development landscape

It is not exactly breaking news to point out that inflation was one of the biggest economic storylines of 2022. At one point over the summer, the 12-month inflation rate reached a 40-year high, and inflation was still sitting at 6.5% in December.

Inflation has an effect across the economy, from big-picture financial metrics to family budgets, and virtually every industry has had to grapple with the ongoing inflationary fallout. The retail development sector is no exception.

But what do those effects look like, and what challenges are retail development professionals facing in the current economic cycle?

Material differences

When it comes to inflation, people often tend to conflate two related-but-separate issues: the direct effect of inflation itself and the impact of rising interest rates. These are two distinct phenomena, but they are linked and often move in tandem. It’s also true that both are having significant effects on the retail development landscape.

With respect to inflation, the most obvious and impactful effect is on construction prices. Because of increase in labor and material costs construction pricing increased dramatically in 2022. CBRE forecasts a 14.1% year-over-year increase in construction costs by year’s end. That comes on top of 2021’s 11.5% increase. Not only is that figure orders of magnitude higher than the 2-4% historical average, but it is also the single highest annual increase since CBRE began tracking cost projections in 2007.

While the overall trend is clear, it’s important to recognize that cost increases are not necessarily consistent across the board and tend to vary and fluctuate by individual material types. Lumber prices may go up significantly, while steel prices are holding steady, and the timing and degree of increases in the cost of concrete may be entirely independent of either of those. Those fluctuations have varying effects on different segments of the commercial development industry. Lumber is not as commonly used in retail construction, for example, but higher lumber prices generally and meaningfully affect multifamily developers. From a material standpoint, retail development is most affected by steel and concrete, and so right now retail is being significantly impacted by a spike in the cost of the latter. 

Along with persistent and burdensome structural challenges in the labor market, the overall trajectory of construction costs has had a noticeably chilling effect on retail development.

Taking an interest

The other side of the inflationary coin is rising interest rates, which have their own effect on retail development. Rising interest rates apply pressure in two ways. First, as interest rates increase, cap rates increase, and values go down. Values are currently 10-25% lower compared to Q1 of 2022 so development margins are tight to nonexistent.  As a result, most proposed developments simply do not make economic sense. The second and less significant challenge associated with higher interest rates is the increased cost of borrowing money. The vast majority of developers utilize debt and the interest they pay on that borrowed money is not insignificant.  Given that interest expense has approximately doubled in the last six months alone, that added cost further chips away at margin. 

Mitigation limitations

Unlike apartment and self-storage owners, whose one-year leases allow opportunity to mitigate the increased burden of rising construction costs and inflationary pressures with annual rent increases, retail developers are generally not in that position. Many leases (particularly these with large anchors) are signed before construction begins—and those rents are almost always predetermined for 20 – 30 years. Even smaller retailers commonly sign 10-15-year deals, limiting the ability of owners and operators to keep up with above average inflationary changes in the near term.

A slowdown and a showdown

Given the factors outlined above, the retail development pipeline has slowed. Most major retailers are not yet willing to increase rents enough to make larger projects pencil. Retail developments in Houston and around the country have largely been put on hold and that will not change until construction costs come down, until retailers are willing to pay higher rents, or until cap rates compress sufficiently to offset construction cost increases.

Some recent indications that inflationary pressures may be starting to ease have come as welcome news to the retail development community. Until those early positive signs turn into a sustained trend, much of the industry will likely remain in wait-and-see mode for the foreseeable future.