Carve Out Right to Future Financially Viable Rent Rate

In order to entice a tenant you might offer very competitive initial rent. At the same time, you need to make sure that you maintain a certain level of income over time. Rent adjustments are typically a part of negotiations with a prospective tenant for space at the property you own. But if you’re particularly worried about the low initial price you’ve given the tenant, there are several ways to make rent adjustments that you should be attuned to. An experienced tenant will be particular about this issue as well. There are methods you can use to determine rent adjustments that both sides can live with.

Predicting Future Is Challenge

Rent is usually the dominant issue between an owner and a tenant, and setting an appropriate rent that will be acceptable at the outset and throughout a long lease term is a challenge. Not only do owners and tenants have to agree on something that approximates a fair market rent for an initial period, but they must also determine a method of fairly adjusting the rent to keep up with inflation and investment expectations over the lease term.

Over time, a property’s rental value will change. With inflation (which has been a historical certainty), a dollar received 10 years from now will not buy as much then as it would today. And investment return rates fluctuate over time. Therefore, the rent will have to change to meet your investment goals—and you must determine when, how often, and to what extent. And your tenants will expect you to spell out in the lease the method you will use for determining future rent adjustments.

You certainly would prefer only upward adjustments, early and often. While that is unlikely to happen, resetting the rent every five, 10, or 20 years is quite common.

Investigate Three Methods

There are three mainstream rent adjustment methods: fixed-rate adjustments, indexed changes (such as using a cost-of-living index), and fair market value resets. Each has its advantages and limitations.

Fixed-rate adjustments. These are predictable and provide a stable basis for obtaining financing. On the other hand, the further out in time the parties set fixed, incremental rent adjustments, the more dangerous the result. Your return may turn out to be too low. Or the rent may be more than even a successful tenant can sustain.

Indexed rent changes. This method also has its advantages and disadvantages. Over the long run, inflation rates adjust for price levels and economic return expectations. There are a variety of published indices, and judicious selection may help approximate the conditions that were taken into consideration when the initial rent was set.

On the other hand, over short time periods, economic dislocation can create a situation where the chosen index is out of line with reality. For example, during times of high inflation when a cost-related index may be high, the market for rental space may be depressed.

Also, indexed rent adjustments are unpredictable, making it difficult for an owner’s or a tenant’s lender to “price” a loan. Certainly, loans relying on leases with indexed rent changes will still be made, but they will almost always be priced assuming the highest inflation expectations. Using index caps and setting annual transitional thresholds may mitigate the downside of applying indexed rent adjustments, but after any reasonable time period the rent may still be substantially out of line with what it would be if the marketplace were setting the rent.

Fair market value resets. Whether used at frequent intervals or only after a number of interim adjustments have already been made, this method allows the parties to return to their initial goal: finding the fair market rent. If they can’t agree on a fair market rent, they can agree that the rent will be reset by appraisal. The challenge is setting the rules:

• Will the appraised value take into account that the tenant is in the space already?
• How will it account for improvements to the space that were made by the tenant?
• What appraisal method will be used, and what qualifications will be required of the appraisers?

After deciding which method—or methods—to use for making future rent adjustments, make sure the details are clearly spelled out in a lease provision.