Are Impact Fees Another Name for Hidden Inflation?

Published Expert Article
by Peter Sengelmann
Senior Advisor at Pinnacle Real Estate Advisors

Investors across the country and here in Denver are worried about inflation. When will it come, and how it will manifest?

From my perspective, inflation already has begun, as many costs in our day-to-day lives continue to rise at a noticeable rate. Do you remember when a sandwich cost under $10? Now a sandwich almost always costs $12, or even more. Other prices are going up too. Occupancy and housing costs have been going up right before our eyes as median home prices have increased 12.36% over the last year, according to a local publication. So how does this happen?

While increased demand certainly is a factor, impact fees and pass-through costs are increasing at an exponential rate. Since these costs are passed on to tenants from building owners, the tenant’s overall occupancy costs increase in kind. Generally, we do not consider impact fees as part of the rents, but when developers and landlords are considering a development or a retrofit, the costs are amortized directly into the rent. Other examples include impact fees charged by municipalities for renovations or developments. The most common surprise in this category here in Colorado is water tap fees.

Water fees vary significantly between counties but often are required when a building is upgraded to a new use or when a developer has a new project. Depending on the tap size, fees can range from $50,000-$400,000, and sometimes even more. Recently, I was told by one apartment developer that these can be the first or second largest single line item for a new development. I would say they can be the single biggest fee for a renovation. While there are consultants who can be utilized to help negotiate these fees, we must recognize that we live in the desert and water is a limited resource. As a limited resource the more we use, the more the water districts charge.

This cost is somewhat unavoidable here in Colorado as we continue to grow, and we all continue paying for it one way or another.

Triple-net fees have been going up steadily as well in recent years. Some examples of this are rising insurance costs due to recent hailstorms and subsequent damage, increased property taxes and rising miscellaneous costs for common area maintenance (landscaping, snow removal, etc.). Labor constraints have forced service providers to pay higher wages and, additionally, these companies are so busy they continually increase their prices. As NNN costs go up, tenants must analyze how they can recoup these costs – or their profits will suffer.

Other rising expenses complicating occupancy for tenants are construction costs. Construction costs are a combination of the expenses for labor and materials, both of which have been increasing dramatically over recent years. On April 20, 2020, as COVID-19 spread across the country and markets were crashing, oil prices dropped so low they were negative for some time. We began to hear some rumblings that labor costs could decrease as oil workers may come out of the fields and get back into construction. However, what we saw was an unexpected surge in residential construction as many set out to improve their homes or build new ones as they were spending a significant amount of more time at home. Reports of lumber being up four to five times in just a couple of years is a combination of increased demand, a lack of supply because the mills were shut down during COVID-19 and the resin producers closed during the snowstorm in Texas. This shows us how much of an impact small changes to an extremely efficient supply chain can have on the demand constrained market.

Recently a new proposal from Denver City Council would require any residential landlord to hold a rental license. This license is a direct cost that most likely will be passed on to the tenants. While this tax does not appear to have a huge impact, these sorts of costs add up for the tenants, making rent more expensive. While these expenses are seemingly apparent, it often is impossible to identify all of them during the due diligence period of a typical transaction. The fees fluctuate during the term of occupancy and some remain constant or are a one-time fee. Trying to determine their impact on said tenants is even more challenging than putting a 3% growth factor into the equation. This creates a real problem for tenants attempting to project their occupancy costs during their tenancy.

What do all these costs mean for tenants, landlords and investors? Inflation is here and while it may not be readily apparent, it creeps into our lives in different ways. Savvy businesses will figure out a strategic way to increases prices, passing the cost on to their customers or landlords. Others will eat these costs, increasing the tenant’s occupancy costs.

Featured in CREJ’s May 2021 Retail Properties Quarterly