Given commercial real estate’s multi-year contracts, rent escalations are an important element present in most leases. In the United States, escalations are typically pegged to inflation but this not the case in Brazil.
Recently, massive rental increases caused by important shifts in the General Price Index – Market (IGP-M) have drawn everyone’s attention, and many questions and concerns have arisen.
Most office leases in Brazil include rent escalations pegged to the IGP-M. Therefore, it is essential to understand the impacts and risks that this volatile index brings to the sector.
IGP-M was initially established as the standard index for rent escalations particularly in the office sector because it includes the National Construction Cost Index (INCC). When analyzing the components of IGP-M we can see that INCC only constitutes 10% of the total composition of the Index while other indices make up the remaining 90%. So, what is the IGP-M made up of?
1) IPA-M: PRODUCER PRICE INDEX WIDE MARKET - 60%
2) IPC-M: CONSUMER PRICE INDEX WIDE MARKET – 30%
3) INCC – M: NATIONAL INDEX OF CONSTRUCTION COST MARKET – 10%
Among these indices, the IPA-M has the largest weight. This index tracks products sold between wholesalers. Over 400 products are included in this index, and many are commodities, traded in US dollars. The graph below shows the 12-month accumulated IGP-M performance and the variation of the US dollar over the last 20 years. Both these metrics trend in very similar ways.
Considering the last Focus-BCB bulletin (11/2020) projection, it’s estimated that the accumulated IGPM for 2020 will be 20%. This means that rental costs are expected to grow by (1/5). This important increase is directly related to the performance of IGP-M.
It is worth noting that the office market continues to be one of the most affected asset types due to COVID-19. During these months we have noted that businesses are hesitant to lease or expand space. In the mid to long term, it is expected that the demand for this type of space will slow down further given that it is unknown when tenants will return.
Property owners are expected to sit down with their tenants and negotiate reduced rental increases that provide them additional revenue while avoiding scaring their tenants away. This complex situation requires the goodwill of both landlord and tenant and reinforces the need for clarity and transparency.