Effects of High Inflation and Interest Rates on Real Estate Developments and Leasing
Real estate developers throughout the country are facing persistent challenges from inflation and rising interest rates while supply chains remain troubled. It is becoming alarmingly common for developers to be forced to amend construction plans to lower costs, pause projects to seek additional funding or even delay or cancel contemplated projects until costs begin to stabilize. It is crucial for developers to keep rising costs and delays in mind while evaluating and negotiating commercial leases and purchase and sales contracts to avoid undesirable outcomes. Below are a few scenarios where developers are facing challenges along with recommendations to navigate through such challenges.
1. Tenant Improvement Allowance
A tenant improvement (TI) allowance is the sum of money that a landlord provides to a tenant in order to cover some or all of a tenant’s costs associated with building out a commercial space to its business needs. As the commercial real estate market is flooded with vacant spaces in the post-Covid world, landlords are more inclined than ever to offer larger TI allowances to entice good tenants to sign a lease. TI allowances are generally either provided to tenants on a turnkey basis where the entire cost of the build-out is paid by the landlord or as a fixed stated dollar amount where the landlord provides a one-time allowance to the tenant for its renovations, usually upon full completion of the build-out. In the current climate, it is beneficial for a landlord to negotiate a stated dollar amount as opposed to a turnkey build-out as any additional costs due to inflation will be the tenant’s financial responsibility. If possible, a landlord should also negotiate to use its own project manager or construction management team to have more control over the tenant’s build-out process and this can almost guarantee that the build-out will stay within the budget or come close to it.
2. Force Majeure
Force majeure clauses excuse a party’s obligations under a contract if an extraordinary event directly prevents one or both parties from performing. Generally, force majeure events include natural events such as hurricanes and earthquakes and sometimes man-made events such as labor strikes and civil unrest. Force majeure provisions are often boilerplate language and should always be reviewed for covered events. Landlords should negotiate force majeure clauses to expand the scope of protection to include delays or excuses from performing obligations due to rising costs from inflation or increased interest rates.
3. Escalation Clause
Escalation clauses can be added to sales contracts or lease agreements to address the rising costs of construction due to inflation. Escalation clauses in new construction contracts can be negotiated to provide the developer with additional compensation if the price of material or labor exceeds a certain negotiated amount. Similarly, escalation clauses can be used in lease agreements to relieve or compensate the landlord on turnkey build-outs if the cost of construction exceeds a certain amount.
The foregoing serve as general starting points to negotiate the effects of inflation on purchase and sales contracts and lease agreements from a developer or landlord’s standpoint. However, sales contracts and lease agreements should be modified to include such provisions as to excuse or delay a landlord and developer’s obligations without leading to a breach of contract.