Ensure Favorable Rent Escalation for Life of Lease
In a perfect commercial real estate world, shopping center and retail leases wouldn’t be subject to variables that could negatively affect your profitability. In reality, inflation—which is impossible to predict with complete certainty—can affect your bottom line unless you and the tenant agree to use “rent escalation” to keep up with the market. This isn’t as simple as it sounds, though. There are several methods that can be used to do this, and pros and cons for each. The one that your tenant suggests during negotiations might not be the best choice for you. But you also need to keep in mind that a tenant could be nervous about agreeing up front to rising costs later. So pay close attention to this part of your lease deal. Here’s what you need to know before negotiating and drafting your rent escalation provision so it’s favorable to you and fair for the tenant.
Realize Importance of Keeping Up with Costs
Rent escalation might be on the back burner if seemingly more valuable items—like cotenancy clauses and exclusive use rights—are up for negotiation with your tenant. But if you agree to the wrong rent escalation formula, that mistake can be costly and last the entire life of a lease, potentially leaving you with having to make up the difference between inflated costs and what the tenant is obligated to pay as escalated rent. It helps to fully understand rent escalation.
“A rent escalation clause is the right of an owner to increase rent throughout the term. Rent escalation is frequently found in renewal options but can be in the original term,” explains Ohio commercial real estate attorney Abraham Lieberman. For example, rent escalation might be used at the beginning of each renewal option term, or exercised annually throughout the renewal option term.
Rent escalation is commonly found in leases with tenants that aren’t paying their full pro rata share of costs and expenses. The ideal scenario for rent escalation is when a tenant has a fixed rent and its common area maintenance (CAM) charges are limited, Lieberman notes. But rent escalation is also appropriate even for a tenant that is paying CAM charges.
One effect of inflation is that the value of what landlords get decreases over time if it stays at the same number. “Landlords figure that by using rent escalation they’re not only presumably recovering their costs, but also recovering the value of the rent as inflation affects them,” Lieberman points out.
Choose Method for Keeping Pace with Inflation
So how can you use a rent escalation clause to your advantage? There are several methods of escalating rent, but choose wisely and according to your specific lease deal. Consider these ways to keep up with rising costs:
#1: Use consumer price index. Using the consumer price index (CPI) is a relatively worry-free method of calculating rent escalation. That’s because the information that the increased rent is based on is objective and readily available online, which limits disputes about numbers with a tenant.
However, beware of the pitfall of using CPI: picking a comparison point that everyone can agree on. “When a landlord calculates the rent escalation according to an index, the big question is which year will be used for comparison,” Lieberman says. For example, will the first year of the lease or just the previous year of the term be used? “If there’s a major jump from year one to year two, then the landlord gets a much better deal if it’s using the previous year instead of year one of the lease term,” he points out. Ask your attorney about adapting the following language:
Model Lease Language
Consumer Price Index. Annual base rent for the option term shall be equal to the product of the annual base rent applicable to the term then expiring multiplied by the greater of one (1) or a fraction, the numerator of which is the CPI for the third month preceding the first month of the option term for which annual base rent is being calculated and the denominator of which is the CPI for the third month preceding the first month of the term then expiring. “CPI” means the Consumer Price Index—All Urban Consumers All Items (CPI-U), U.S. City Average (1982-1984 = 100) published by the Bureau of Labor Statistics of the United States Department of Labor. If the Bureau of Labor Statistics shall change the base period, then to make any computation required by this Lease, the Index shall be converted to the new base period by substituting new index numbers for the old index numbers, if appropriate, or by applying the formula supplied by the Bureau for converting to the new base period. If such Consumer Price Index of the Bureau of Labor Statistics of the United States Department of Labor is discontinued, then Landlord shall select another index published by a department or agency of the United States government to be substituted for the predecessor index with any appropriate adjustments required because of the predecessor index. If no such index is so published, then Landlord shall substitute an index prepared by an appropriate government agency, corporation, or other entity.
#2: Use costs. “A landlord can do a rent escalation based on its own costs, rather than, or in addition to, a CAM pass-through for the tenant," Lieberman says. Keep in mind that basing rent escalation on your operating costs to run the shopping center can lead to disputes. The tenant can argue that you never should’ve included a certain item in operating costs to begin with, whereas formulas like CPI or using a fixed percentage are easy to interpret.
Model Lease Language
Increased costs. Annual base rent for any lease year after the first lease year shall be equal to the product of the annual base rent for the immediately preceding lease year multiplied by the greater of one (1) or a fraction, the numerator of which is Landlord’s Operating Costs for the immediately preceding lease year and the denominator of which is Landlord’s Operating Costs for the first lease year of the term. Until Landlord’s Operating Costs for the preceding lease year are determined, Tenant shall pay annual base rent for the lease year based on the annual base rent for the preceding lease year. Tenant shall pay any deficiency in annual base rent attributable to the adjustment required to be made pursuant to this section within thirty (30) days after Landlord notifies Tenant of Landlord’s Operating Costs for the preceding lease year. As used herein, “Landlord’s Operating Costs” means [insert definition].
#3: Use fixed percentage. Some owners and tenants agree to base rent escalation on a fixed percentage, which can be useful in situations where a tenant is going to incur a significant amount of costs to remodel the space. The tenant will be operating thinly for the first year or two of the lease; using a fixed percentage method, it can get a break on first year rent but make it up to the owner in the next years of the term, Lieberman says. He points out that it’s a way to give a tenant a rent break that can help it offset an initial outlay of cash.
This is also a good method for fixed rent leases. The landlord and tenant set either a dollar amount or an exact percentage. And as with using the CPI, a fixed percentage makes it easy to see how the numbers should work out, minimizing the potential for disputes.
Model Lease Language
Fixed Increases. Annual base rent shall be as follows:
Lease year Annual base rent
Commencement date - __________, 20____ $_____________
__________, 20____ - __________, 20____ $_____________
__________, 20____ - __________, 20____ $_____________
Carefully Word Lease Language for Deflation
Don’t focus solely on inflation in relation to rent escalation, or you could end up drafting a provision with a formula that isn’t worded correctly to deal with deflation—ultimately leaving you collecting lesser rent. “It’s always a good idea to account for deflation by using lease language that provides if the CPI goes down, the rent will not be less than the first year, or the rent will not be less than the previous year,” says Lieberman. “Draft the rent escalation clause so you never lose ground,” he stresses.
Insider Source
Abraham Lieberman, Esq.: Member, O’Toole, McLaughlin, Dooley & Pecora, 5455 Detroit Rd., Sheffield Village, OH 44054; www.omdplaw.com.