Owner's Guide to Mitigate Expense Inflation

For simplicity, I have made the net operating income consistent between alternatives, although that is not necessarily how the structures may perform in the market.

 

The concept is that all fixed, variable, and management expenses are passed through to the tenant in the absolute net lease structure but the bottom line – or net operating income – is similar or consistent in either structure as the base rents make up for the difference in expense incurred.

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With the above in mind, this article analyzes expense categories that are currently increasing at above average rates relative to historical trends. This bring into question how property values may be affected if expenses continue to rise at a faster rate than historical expense inflation.

 

Will tenants accept higher-than-historical-average increases to expenses?

Or, will base rents need to be reduced to maintain a constant total occupancy cost [1] that is trending more consistent with the rate of historical expense inflation, all else being equal? 

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What are some strategies a tenant or landlord could employ to reduce their expense exposure? Let’s dive in.

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Real Estate Taxes

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Trends: Property taxes are the lifeblood of local governments and municipalities across the United States, accounting for over 70% of all local tax revenue.

 

In Pennsylvania, real estate property taxes are collected by each county and distributed to the school district, municipality, and county, respectively. The school district typically gets the lion share of the property tax income while the municipality and county split the balance depending on various factors. Property taxes fund schools, parks, roads, and other public works and services.

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Across the United States, the average effective tax rate of single-family homes was 0.9% in 2021, down from 1.1% in 2020.

 

Across Pennsylvania, the effective annual property tax rate stands at 1.43%, the 5th highest among all states.

 

The effective property tax rate is calculated by taking the total amount of taxes paid on owner-occupied homes in a given area as a share of the total value of those homes. [2]

While an effective property tax rate is useful for comparing taxes at the state level, it is important to note that property tax rates can still vary considerably within a given state.

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Threats: Providing competitive salaries to teachers tops the list of threats to stabilized property taxes.

 

School districts are having an incredibly difficult time attracting and retaining qualified educators and will likely need to increase their wages to fill the void. 

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Secondly, according to a 2018 report card administered be the American Society of Civil Engineers, Pennsylvania scored a “C -" for public infrastructure. While this may have satisfied your high school math teacher, it’s a scary grade to think of while you are crossing any bridge in the Commonwealth. [3]

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This will continue to be near the top of the list for policy makers and requires more tax revenue.

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Strategies: Tax Appeal.

 

The property assessment is translated into “Implied Market Value” via the common level ratio which is different for each county. The common level ratio changes from year to year and is calculated based on the trend in sale prices from 2 years prior. That is, the CLR is a retroactive calculation but is applied to your current assessment.

 

Given that there are more residential sales than any other property type, the trend in residential pricing is the overwhelming influence on how common level ratios trend.

Therefore, as of Fall 2022, it is safe to presume that Implied Market Values will continue to trend upward for the next 2 – 3 years despite how the current real estate market is performing at that time.

 

This could mean an increased likelihood for appeal candidates if markets decrease

during that same time period.

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Insurance 

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Trends: Pennsylvania is not located in a particularly risky area when it comes to hurricanes, tornados, or other catastrophic natural events.

 

However, insurers globally are faced with increased risk due to the uptick in non-traditional catastrophes and the lack of a historical model to measure this risk against.

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Freezing temperatures in Texas, tornadoes devastating parts of Kentucky and Tennessee, a record-breaking snowstorm in Madrid, wildfires in Siberia. These kinds of events contributed to global weather catastrophes that totaled an estimated $343 billion in 2021, compared to $297 billion in 2020. [4]

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“Climate change has altered the risk equation, so that the past is no longer a reliable indicator of the future,” writes Aliya Alikhanbayova for Chartis Research. “As the frequency and severity of natural disasters has increased, measuring and quantifying future risks has become an incredibly complex task.” [5]

 

Simply put, the 100-year catastrophe is becoming more frequent.

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Another impactful trend is that – while PA is not at a high risk of catastrophic loss due to natural disaster – insurers “pool risk” over large geographic areas. Therefore, the increased overall losses for a property insurer in a high risk area (due to climate change, for instance) will have someeffect on insurance premiums on properties in low risk areas (like PA).

 

In a sense, premiums from low risk areas subsidize high-risk areas.

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Threats: Pennsylvania ranks second in the U.S. for potential structural damage due to increased flooding and three Pennsylvania cities are at serious risk of office, retail and residential damage, according to a study by First Street Foundation.

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The “4th National Risk Assessment: Climbing Commercial Closures” study focuses on the impact to commercial real estate looking at the potential structural damage, lost days of operation and downstream economic impacts based on current and future estimates of flood hazards. It assessed the current and future climate adjusted risk of damaging floods to commercial properties, and the average annualized costs of those damages.

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According to the study, Pennsylvania has one of the highest aggregated total structural damage costs across office buildings, retail buildings and multi-family buildings at $1.22 billion, behind only Florida. [6] Flood risks for 20 metropolitan areas were analyzed and showed that Harrisburg, Philadelphia and Pittsburgh could face significant damage-related losses.

 

• The Pittsburgh region has 36% of all office, retail and multi-unit residential properties at risk of flooding this year, with estimated damages of $448 million.

• The Philadelphia metro area, 10.7% of all commercial properties face the risk of flooding, amounting to an estimated $208 million in damages.

• The Harrisburg area has 31.8% of all commercial properties at the risk of flooding with estimated damages of $148 million.

 

It is only a matter of time before a substantial loss due to flood in PA results in increased premiums for most of its residential and commercial property owners.

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Strategies: Revisit your insurance policy. Costs of construction have rapidly increased leaving many properties underinsured relative to the cost required to replace – or rebuild – those buildings. 

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Electric

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Trends: Pennsylvania Electric Utility Retail Price is at a current level of 0.1264, up from 0.1212 in September 2022 and up from 0.1008 in 2021.

 

This is a change of 4.29% from last month and 25.40% from one year ago. [7] 

In the last 20 years, the price of grid energy has increased 2.79% per year on average, according to the U.S. Energy Information Administration (EIA). And the EIA is projecting a 2.54% increase from 2022 to 2023.

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Prices are up because of the rising costs of natural gas, which generates about half of the state’s electricity. “The price hikes are directly related to the ongoing volatility in the wholesale energy markets,” said Patrick Cicero, Consumer Advocate for the Pennsylvania Office of Consumer Advocate. “And the reason that the gas prices are high is because [the country] has significantly increased exports of liquefied natural gas and has not increased natural gas production.” [8]

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Threats: The primary threat to stabilized electric costs is lack of natural gas production in the United States. 

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Secondly, even as utility companies add cleaner, cheaper renewable energy into the electric grid, they face enormous costs to maintain and expand the grid.

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Since the US was one of the first countries to build out an electric grid, it also means that our system is one of the oldest. Utility companies spend hundreds of millions of dollars every year upgrading their towers, lines, substations, and transformers. These costs continue to drive up the cost of delivering electricity, even as cheaper generation sources come online. [9]

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Strategies: Install Smart Meters.

 

A smart meter is an electronic device that records information such as consumption of electric energy, voltage levels, current, and power factor. Smart meters communicate the information to the consumer for greater clarity of consumption behavior, and electricity suppliers for system monitoring and customer billing.

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Service HVAC.

Regular air conditioner maintenance along with clean air filters help ensure efficient operation of your cooling system.

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Replace Windows.

New windows save energy, but they may not be the most cost-effective way to lower your bills.

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Install Solar.

How much you pay to have solar panels fitted will depend on the size of your roof and the type of system you choose. Having solar panels installed isn’t cheap, but costs have fallen over the years and the payback period is estimated at 7 – 8 years according to most sources.

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The Standard Offer. Most Pennsylvania electric distribution companies (EDCs) offer residential and small business customers a choice to participate in a voluntary electric shopping program known as the Standard Offer Customer Referral Program. The Standard Offer includes a fixed-rate price, 7 percent below the electric utility’s current Price to Compare (the price the utility pays for electricity), for a term of one-year with no cancellation or termination fees.

A Standard Offer customer can cancel the agreement at any time. [10]

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Water & Wastewater

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Trends: Water and wastewater cost trends are specific to region and supplier.

 

However, recently there has been a rapid increase in most regions which may be a sign of things to come for those regions currently unaffected. 

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Take Aqua Pennsylvania, for example. A subsidiary of Aqua, Aqua Pennsylvania is a Pennsylvania water company that serves 1.4 million people. As of May 2022, the average monthly bill for an Aqua residential water customer in its main rate zone will go up 12% from $69.35 to $77.51.

An average Aqua residential wastewater bill will go up 59%, from $55.51 to $88.18.

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Most Aqua customers get only water service and pay a local entity for wastewater service, usually a town or a municipal authority. In recent years, Aqua and other private companies have been aggressively buying up public sewer systems – which critics say is partly responsible for the soaring rates – to pay for the premium acquisition prices, as well as expensive improvements to systems that have been neglected under public ownership.

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The rates for other water and wastewater providers are also increasing as utilities modernize their aging systems to comply with stricter environmental regulations on wastewater discharges and water purification standards.

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Pennsylvania American, the state’s largest private water company, has increased residential water bills 9% and sewer bills 30% in two steps over the last two years. The average monthly residential bill for a Pennsylvania American water customer is now $62.80 and $78.41 for wastewater. [11]

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Threats: The previously mentioned Infrastructure Report Card from 2018 indicated the following:

 

• As the state with the most combined sewer overflows, billions of gallons of untreated sewage enter into our streams every year and is reflected through Stormwater and Wastewater being graded a D-.

• Pennsylvania’s aging drinking water mains saw an over 40% increase in breaks contributing to a D grade.

 

The cost to repair aging infrastructure and trend towards privatizing water and wastewater will contribute to above average compound growth rates for this expense category indefinitely. 

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Strategies: Check for Leaks. Undetected leaks are one of the major problems that lead to

high water bills. 

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Install Smart Meters. Installing smart meters to track your water supply will make sure that you only pay for what you use. Smart meters help you keep an eye on exactly how much you are using – so you can make the necessary adjustment if you are using too much and hence reduce your water bills.

Upgrade Equipment. If your building relies on outdated equipment, your water bills will suffer. It is recommended that you upgrade to low-flow appliances as they can save you an incredible amount of water.

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Natural Gas

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Trends: A recent report from the Independent Fiscal Office (IFO) shows Pennsylvania natural gas prices have spiked to their highest level in the last decade.

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In August 2022, UGI announced that Pennsylvania consumers will be increasing on September 1. Gas customers will pay 7.6% more. The average monthly bill will go from $106.69 to $114.83.

The IFO expects prices to stay on the upswing because of global pressures. [12]

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Threats: The primary threat to stabilized natural gas costs is lack of natural gas production in the United States.

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Strategies: Turn Down Your Thermostat. You can save as much as 3% for each degree that you turn your thermostat down during the winter. 

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Take Care of Your Furnace. Have your furnace cleaned and checked out every year to keep it running at peak performance. Clean and replace the air filter on your furnace regularly.

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Turn Down the Tank. You can reduce your energy consumption by turning your hot water tank down to 120 degrees. For every 10 degree reduction in temperature, you can save between 3% and 5% on your water heating costs. 

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Over the long term, energy efficiency improvements to your home can reduce your natural gas usage and save you money. [13]

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Building Repairs & Maintenance

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Trends: Building repairs and maintenance includes labor and material costs – each of which have been incredibly volatile over the past 12 – 24 months.

 

Producer Price Index (PPI) Material Inputs (which exclude labor) to new construction averaged less than 1% inflation per year from 2012 to 2017. Cost decreased in 2015 and 2016, the only negative costs for inputs in the past 20 years. Input cost increases averaged over 5% for 2018-2020. Then in 2021 input cost increases soared to 22%, the highest ever recorded. [14] Lumber, steel, and many other materials critical for construction projects have experienced skyrocketing increases in pricing.

 

While the root of the problem was supply chain disruptions due to the COVID-19 pandemic, new challenges — including geopolitical risks — continue to put pressures on pricing. And an increase in government-led infrastructure activity is further increasing demand for construction materials. [15]

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At the same time, the available construction workforce is shrinking as an ageing cohort of skilled workers either retire or face local restrictions related to travel and workers move into other professions given competitive salaries elsewhere.

 

Additionally, over 40% of the current U.S. construction workforce is expected to retire over the next decade. The current shortage of some 430,000 construction-industry workers is fully expected to expand over the next two years. [16]

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While construction costs for most materials have stabilized, the real cost on the construction side is “opportunity cost” being passed onto users of construction services. In other words, demand for construction jobs is outpacing capacity to such an extent that construction companies have unsurprisingly been charging a premium for work.

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This is ultimately how we realize labor cost inflation.

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One of the best predictors of construction inflation is the level of activity in an area. When the activity level is low, contractors are all competing for a smaller amount of work and therefore they may reduce margins in bids.

 

When activity is high, there is a greater opportunity to submit bids on more work and bid margins may be higher. The level of activity has a direct impact on inflation and higher interest rates translates into less projects being financially feasible to undertake. All else being equal, higher interest rates may curb construction cost inflation due to lower demand for construction services.

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However unlikely, it begs the question if construction cost deflation is in play.

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Threats: Material Costs. Overall cost inflation for materials is expected to begin cooling by the end of 2022 and largely return to typical levels by mid-2023.

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However, given the large number of construction inputs—many of which are often subject to geopolitical risks such as tariffs and sanctions—costs for some materials may remain volatile. [17]

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Labor Costs.

Given the Infrastructure Investment and Jobs Act (IIJA), the infrastructure construction industry is about to experience a surge of resources, but the talent shortfall threatens the infrastructure industry’s ability to take advantage of this once-in-a-generation opportunity.

 

To compete with other industries, attract a new generation of talent and maximize the output of the current workforce, there is a strong case for the industry to consider advanced digital technology.

Not only do these solutions improve efficiencies and collaboration, but they will also appeal to a younger, tech-savvy generation who expect to be equipped with these tools.

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To execute the ambitious agenda of the IIJA, the industry will need to build a skilled workforce that currently does not exist.

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Strategies: Fixed Price Contracts. Fixed-price contracts have the advantages of predictability for a specific maximum cost.

 

However, they may come with a higher price because contractors will add a percentage to lower their risks and cover unexpected expenses that were not in the original bid.

 

Partnerships.

Closely monitor the economic situation on both a micro level, in terms of domestic supply issues and their potential impact on your project, and on a macro or global scale.

 

Many project owners do not have the resources for this level of market analysis and insight.

Therefore, strategic partnerships are key to staying informed about not only what’s happening right now, but what’s likely to happen in the future, and most crucially, what adjustments are necessary to control your costs and keep your project moving smoothly forward.

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Communicate.

Communication is critical so that both owner and contractor are aware of the terms and conditions of the project and that unexpected costs may occur. Communication is vital at all levels of the project team. The owner should set the example by establishing a culture of communication and trust.

The construction manager should communicate about potential roadblocks and other challenges.

 

In turn, the contractors should communicate about cost changes and fluctuations in material delivery dates.

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Clear and thorough communication can help to anticipate changes and minimize delays, both of which can directly serve to control costs.

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Conclusion

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All of this goes out the window if there is government intervention – specifically consumer subsidy – in any or all of these expense categories.

 

Nevertheless, forecasting expenses to compound at 2 – 3% (as many owners do) may be insufficient to meet the threats we face. 

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From a landlord’s perspective, the most attractive strategy to mitigate any risk is to pass these expenses onto a tenant.

 

Ultimately, the question is how much risk the tenant is willing to undertake. And does that transfer of risk result in a lower base rental rate? In any event, the need to clearly define and negotiate expense caps and expense stops has never been more important. [18]

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For owner occupants, does expense inflation make ownership cost prohibitive? Do sale-leasebacks make more sense to transfer this risk to investors as opposed to undertaking it yourself? 

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The reader should acknowledge that residential and commercial statistics have been somewhat conflated throughout this article; however, the principle holds which is, “Will expenses be able to be passed through to tenants?”

 

All else being equal, if operating expense inflation outpaces rent appreciation, property values will be negatively affected in a material way. Therefore, it is extremely important for a landlord to understand how to mitigate these risks with such volatile market conditions forecasted indefinitely.