Intro - Escalation Clause in Your Commercial Lease

A commercial escalation clause is often included in most commercial real estate leases. This clause allows the landlord to increase the rate of your rent according to a specific timeline or as a result of certain triggers included in the clause. As a result of the inclusion of the commercial escalation clauses, your rent will not be fixed over time. Hence, it is important to pay attention to the following commercial escalation clauses, so they do not have a huge impact on your occupancy cost over the period of time that your lease spans.

 

When Does it Escalate?

Unless you were lucky enough to negotiate a lease that remains fixed for its entire life, you will have to deal with the provisions of its escalation clause. This clause determines when your lease payments will go up and how much they will cost you. While escalations might seem far away when you first sign your lease, they will come into play eventually.

 

One of the first things that your lease escalation clause defines is when your lease payments will go up. Many leases in multi-tenant buildings have annual increases tied to the lease's anniversary date. If your rent payments started on March 1, you can expect them to go up on March 1 next year.  Leases in single-tenant buildings might have escalations occur at three- or five- year intervals. The only way to be sure, though, is to read your lease.

 

How Does it Escalate?

Usually, your lease's escalation clause will specify one of these three types of increases:

  1. Fixed increase. These increases are for a set dollar amount per foot (or for the entire space). For instance, your $35 per square foot lease might go up by 75 cents per year. Bear in mind that this could mean that the increase goes down on a percentage basis over time

  2. Percentage increase. In this structure, your rent escalates by a set percentage. So, if you have a $35 per square foot lease with 2 percent annual increases, it would go up to $35.70 in the next year, then $36.41 the year after that. These increases usually compound, which can add up over time.

  3. Consumer Price Index (CPI) or other inflation-based increase. When you have a CPI escalation clause, your rent will go up in sync with a pre-defined measure of inflation. If inflation is low, your escalation is small. But if inflation spikes, your rent could spike along with it. If you have this type of escalation in your lease, look carefully to see if there is a cap on how much it can go up in a year.

 

Escalation Clause in a Renewal Option 

Many leases contain renewal options that are set to a percentage, usually 95, of the fair market rent for space at the time of the renewal. Building a renewal clause has two key problems:

  1. Determining fair market rent can be a complicated, time-consuming and even expensive process unless the landlord and tenant agree.

  2. If rents in the market increase significantly, the tenant could be locked into those rents.

A more tenant-friendly formulation is to set the option rent to be a fixed increase over the rent in place at the time of the renewal. For leases with annual escalators, the increase is usually relatively close to whatever the annual escalation would be. For flat leases, the increase usually works out to two or three percent per year. In either case, this gives the landlord some income growth while protecting the tenant from skyrocketing rents.

 

Rent Escalation Clauses Are Not Always Linked to Operating Costs

As mentioned above, rent escalations are not always associated with operating costs. Landlords may opt to raise rent annually in order to offset the cost of inflation. With these types of rent escalations, the lease will specify when the increase will occur and how it is calculated.

 

Actual Rent Clauses Can Be Fixed or Variable

Rent escalations that are tied to actual rent can be fixed or variable. Fixed rent increases are often referred to as stepped increases. With this structure, the landlord increases your rent by a specified amount at specific points during your lease, such as every year or once every three years. The increase is usually based on square footage, so your rent could go from $20 per square foot to $22 per square foot.

 

Variable increases are called indexed increases. Typically, these increases are tied to a third-party indicator like the Consumer Price Index. As the index changes, your rent increases in the same amount. With this type of rent escalation, a cap should be put in place to protect tenants from sky-high sudden increases.

 

Operating Cost Escalations Can Be Handled in Different Ways 

As with actual rent increases, operating cost-associated rent escalations come in different forms. With pass-through escalations, your rent increases only when certain costs for the landlord increase. Normally, these types of rent escalations are only triggered by property tax increases. Direct operating cost pass-through escalations allow landlords to pass along any increases in operating costs, such as security and maintenance. This type of rent escalation can prove very costly for tenants.

 

Direct Operating Cost Pass-Through Escalation

Similar to the tax pass-through escalation, this escalation clause increases the rate of your rent when there is an increase in the operating costs. Operating costs include security, billing, and maintenance costs.  The rental increase is calculated by the amount of the building space you occupy. The lease should specify exactly what costs are included in the calculation. This type of escalation clause is not favorable to the commercial real estate tenants because it is more likely to impact businesses, and cost increases can be very unpredictable.

 

Understanding these major commercial escalation clauses helps you to know what to look for when signing a commercial real estate lease. It is important to verify how certain calculations are done to avoid being ripped off your hard-earned business revenue. Make sure that the number that you come up with matches your new rent rate. Don't assume that the landlord has calculated things correctly. If you discover a discrepancy, ask for clarification.

 

You Could Owe More CAM at the End of the Year

In some cases with direct operating cost pass-through escalations, landlords calculate a budget for common area maintenance fees at the beginning of the year. The fees are based on estimated costs and then divided among the tenants in amounts that correlate to the amount of the building that they occupy, respectively. At the end of the year, the landlord could have the right to demand a payment from you to cover any shortages. On the flip side, you could receive a refund if you overpaid.

 

Tax Pass-Through Escalation 

A tax pass-through escalation clause implies that you will be responsible for paying a percentage of the increase based on the amount of space that you occupy in the event of an increase in the landlord’s property taxes. Although the increase is not predictable, this type of escalation may never affect your business and is generally more favorable most other options.

 

Stepped Increase Escalation

With a stepped increase escalation clause, the landlord increases the rate of your rent periodically by a pre-determined amount. For example, your rental rate may increase by $5 per square footage per year. In this example with a five-year lease, you might pay $30 per square foot for year one, $35 for year two, $40 for year three, $45 for year four and $50 for year five. Stepped increases are favorable for tenants, as they give you a clear picture of what your costs will be over time.

 

Indexed Escalation

This type of escalation clause implies that your rent rate increases when an established index increases. The commonly used index is the Consumer Price Index (CPI). The CPI is published by the Bureau of Labor Statistics. It is important to note that CPI can be very difficult for corporate tenants to study, and it can lead to a dramatic increase in occupancy costs. Hence, it is essential to work with a tenant rep. Having a tenant representative by your side during the negotiation process will help you in getting a more favorable commercial escalation clause.

 

Always Calculate Escalations Yourself

No matter what type of rent escalation is stipulated by your lease agreement, it is important that you take the time to calculate increases on your own. If you can't arrive at the same figure as your landlord, ask to be shown exactly how the increase was determined.

 

Managing Rent Escalations 

For many tenants, a rent escalation is a yearly occurrence. They can come in two basic types -- fixed and variable -- although they can also come into play when your lease comes up for renewal. While some tenants are able to avoid them, they are usually an unavoidable cost of occupying real estate and need to be managed and planned for. Their terms can vary from lease to lease, so it's best to carefully abstract your lease so that you can predict both what will happen and when.

 

Fixed Escalations

Some leases are structured with fixed escalations. For instance, if you have an office space that rents for $24 per square foot, the lease may be written with 50 cent annual increases. This means that, after a year, the rent will go up to $24.50, and a year after that it will go up to $25, continuing until the lease expires. Others are written with a flat percentage. A $24 lease with 2 percent annual escalators would go to $24.48, then $24.97, then $25.47 and keep going up. Read your lease carefully, though, because the way that the escalations get calculated can be complicated, especially when it comes to rounding off rents that are less than one cent. Over time, these small issues can add up.

 

Variable (CPI) Escalations

Some leases have a rent escalation system that gets tied to an outside metric, like the Consumer Price Index. Under these systems, if inflation (as measured by the CPI) is 1 percent, your rent will go up by 1 percent. If inflation is 10 percent, though, your rent goes up by 10 percent. It isn't uncommon to see these leases structured with a cap. For instance, the lease may say that it will go up according to the CPI or 3 percent per year, whichever is less. This structure is very tenant-friendly since you get small increases when inflation is low but, if inflation goes up, your rent doesn't keep up with it and you end up saving money over time.

 

Rent Escalation Timing

Rent escalations typically occur at one of three times:

  • Annually (usually on the anniversary of the lease's effective date)

  • After a set number of years (frequently every three or every five)

  • At the execution of a renewal option

Generally, the longer you can put off a rent escalation, the less expensive it is. For instance, a tenant with a $24 lease with 50-cent annual escalations would pay $24 for a year, then $24.50 for a year, then $25 for a year, then $25.50 for a year. If the same lease was structured with a $1.50 escalation every three years, the tenant would pay $24 for three years, then pay $25.50 for three years. Deferring escalations has one drawback for the tenant, though. Instead of having small increases that can be easily built into an operating budget, it ends up with fewer, larger increases that may negatively impact cash flow.

 

Option Escalations

When a tenant executes an option to renew, the rent escalation clause can be structured in a few ways. Some continue the current lease's terms, so if your lease goes up 2 percent per year, it will go up 2 percent per year in the option period. Others have a single large increase, and others reprice the rent to fair market value or some fraction of it. The latter choice can be dangerous since, if the market's rent markedly increases, you could end up facing much higher rents when you renew, potentially making your space unaffordable.

 

Using Indices to Prevent Excess Rent Escalation 

Nearly all corporate real estate lease agreements contain a rent escalation clause. The concept is similar to the technique used in a lease for a “freestanding” commercial space occupied by a single tenant. The provision ensures that landlords receive a fixed return on the space as well as reimbursement for a number of capital costs and expense items, including insurance, taxes, maintenance , and operations.

 

Landlords and tenants can structure a rent escalation into the lease in a number of ways:

  • Fixed amount annually

  • Actual increase in the landlord’s capital costs and expense items

  • Percentage increase based on the Consumer Price Index for all Urban Consumers (CPI) or other available indices.

 

A traditional corporate real estate lease can use a combination of these methods. Most leases use the fixed amount calculation followed by the Consumer Price Index. The CPI provides a monthly measurement of the impact of inflation on a basket of goods and services—food, housing, transportation, medical costs, entertainment, and other items.

 

You can use an index like the CPI to evaluate rent escalations in your lease and make sure you are not being charged excessively. Here’s how:

 

How to Control Base Costs 

Whether you use the CPI or another index, the same advice applies here: control this aspect of the rental agreement by making sure that that the contract contains clear and accurate definitions and language to control unfixed expenses and exclude unreasonable costs.

 

The rental agreement can achieve these objectives by providing a realistic base rent that does the following:

  • Excludes costs that are not reimbursable to the landlord

  • Adjusts bases and expenses to prevent unreasonable increases

  • Caps rent increases.

 

The lease should also require the landlord to keep certain records pertaining to the expenses and give the tenant the right to audit those records. In most cases, the lease does not allow for a rent decrease.

 

Conduct a Complete Review 

There are also other factors that tenants need to assess as part of a rent escalation evaluation. Determine how the index affects your tenancy in relation to the following questions:

  • Will the full rent be escalated or only a percentage?

  • Will you use the full value of the index to calculate the rent escalation or just a percentage?

  • Will the rent escalation clause take into consideration other cost increases?

Regardless of the index that you and the landlord agree to, it is important to weigh all of the above factors to prevent excessive rent escalation.

 

Conclusion

Signing a commercial lease is a major step for your business. For many tenants, a rent escalation is a yearly occurrence. They can come in two basic types -- fixed and variable -- although they can also come into play when your lease comes up for renewal. While some tenants are able to avoid them, they are usually an unavoidable cost of occupying real estate and need to be managed and planned for. With this guide, you will be able to navigate your commercial rent escalation clauses.

 

Here are a few other articles we think you'll enjoy:

You Need a Tenant Rep Broker: Here's Why

10 Commercial Lease Clauses You Should Know

What to Know About Your OPEX (Operating Expenses)

 

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