Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / How Stagflation Is Reshaping the Commercial Real Estate Market
Transcript
- Lucas: So we talk a lot about what stagflation does to the price of groceries, to your car loan, to your electric bill. But there is a whole other layer of the economy that is getting squeezed in a way that is harder to see day to day, unless you happen to own or lease commercial space. Luna: Commercial real estate. And I think most people's mental picture is still stuck in 2023 — empty office towers, WeWork imploding, the doom loop narrative. Lucas: Right. And parts of that story are still very real. But the picture in mid-2026 has gotten more interesting because the stagflation dynamic is hitting different property types in completely opposite ways. Let's start with offices. Luna: What's the number that stands out to you? Lucas: Downtown office vacancy nationally is hovering around 25 percent. That is down a hair from the peak in 2024, but it is still higher than anything we saw in the 1990s or 2000s. And the thing is, asking rents have actually gone up about 3 percent year-over-year, according to data from CBRE. Luna: So landlords are raising rents even with a quarter of their buildings empty? That seems like it doesn't add up. Lucas: It doesn't, unless you look at what is actually being paid versus what is listed. Effective rents — the real amount after concessions — are flat to slightly negative in most major markets. Landlords are offering three to six months of free rent on a five-year lease, higher tenant improvement allowances, everything short of cutting the base rate. Because if they cut the base rate, that resets the valuation of the entire building. Luna: So the nominal rent stays high on paper to keep the property appraisal from plunging, but the tenant is paying much less in practice. That feels like a game of chicken. Lucas: Exactly. And the question is how long banks and landlords can keep that up. But what I find more interesting is the divergence with industrial real estate. Warehouses and distribution centers had a monster run during the pandemic, vacancy rates below 4 percent, rents up 20 percent a year. That has cooled. Luna: Because e-commerce growth slowed and companies stopped building out so much inventory after the 2022-2023 destocking cycle. Lucas: Right. Industrial vacancy has crept up to about 6 percent nationally. Still very low by historical standards. But here is the stagflation twist: construction costs for new warehouses have not come down. Lumber, steel, concrete, labor — all still elevated. So even though demand has softened, the supply of new space is limited because it costs so much to build. Luna: That keeps a floor under rents. If you need space and there's not much being built, you pay closer to peak pricing. Lucas: Right. And that has a knock-on effect for small and mid-size businesses. If you run a local furniture maker or a food distributor, your warehouse lease is probably up for renewal this year or next. And you might be looking at a 15 to 20 percent increase, even though the market has softened a bit. Your landlord's costs are higher — property insurance alone is up 25 to 30 percent in some areas because of climate risk repricing. Luna: So the cost pass-through is real. That's the inflation part of stagflation. But what about the growth part? If the economy is slow, how are tenants absorbing those rent increases? Lucas: They're not, in many cases. We are seeing more small businesses give up their physical space entirely and go remote, or share warehouse co-op space. The Fed's July Beige Book, which just came out, noted that consumer spending is showing 'warning signs' — people are pulling back. The World Cup gave bars and restaurants a nice bump, but the underlying trend is cautious. Luna: And that directly hits retail real estate. Strip malls and storefronts in secondary locations are seeing more vacancies again. Lucas: Yeah. The retail vacancy rate nationally is around 7 percent, but in lower-income suburbs it's closer to 12. You have a two-tier market. Class A malls with high foot traffic are doing fine. The rest are struggling. And with interest rates where they are, refinancing those properties is brutal. A lot of loans coming due this year are facing rates that are 300 to 400 basis points higher than the original mortgage. Luna: So you've got a wave of potential distress, but it's not a 2008-style crash because the lending standards were tighter this cycle. More equity in the deals, less speculative construction. Lucas: That is an important distinction. But the stress is real, and it's compounding in slow motion. One data point I keep coming back to: the producer price index for June showed a surprise decline of 0.3 percent, largely because of a drop in gasoline. That is the 'flation side easing a bit. But core PCE, the Fed's preferred measure, is still running above 3 percent annualized. So the cost of services — rent, healthcare, insurance — is still sticky. Luna: And that sticky service inflation is exactly what makes commercial real estate such a tough spot right now. Because property owners can't easily cut their operating costs, and tenants can't easily absorb higher rents. Lucas: Right. And it creates this weird dynamic where you have two sets of inflation numbers that seem to contradict each other. CPI came in at 332.6 for June, down a bit from the prior month. But the 10-year breakeven inflation rate actually ticked up to 2.24 percent. The bond market is saying inflation isn't dead yet. Luna: That's the stagflation narrative in a nutshell: the economy is not growing fast enough to generate strong demand for space, but costs are still rising. And the commercial real estate market is ground zero for that tension. Lucas: And if you're a listener who finds this kind of analysis useful — walking through the economy with a specific lens — let me just say that this show is ad-free and it stays that way thanks to listeners who choose to support us. If walking through the economy with us has made something click for you, you can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that makes a big difference for keeping this independent. And we really appreciate it. Lucas: Alright, so let's zoom back out. The big question for the rest of 2026 is whether the softness in commercial real estate starts to spill over into the banking sector more visibly. We've seen a few regional banks take reserves for loan losses, but nothing like a crisis. The Fed's stress tests this year assumed a severe commercial real estate scenario, and the big banks passed. But smaller lenders have more exposure. Luna: Especially banks with heavy concentrations in office loans in central business districts. Those are the ones to watch. Lucas: Exactly. And the thing that keeps me up at night is not a sudden crash, but a long, grinding adjustment where properties slowly lose value, loans get extended again and again, and capital gets trapped in zombie buildings that should probably be converted to residential or torn down. Luna: Conversion is happening, but it's expensive. And with construction costs high, the math only works for a fraction of buildings. Lucas: So you end up with a commercial real estate market that is not crashing, but not recovering either. It's just grinding sideways. Which, in a way, is the perfect physical manifestation of stagflation.