Rent escalation clauses are standard in most commercial real estate leases. If your company leases space, your rents are probably set up to increase automatically over time. While escalations of 2%-3% per year might not necessarily seem like a big deal, they can actually have a large impact on your occupancy costs over the length of the lease.
Lease escalations come in a few different forms. Some leases have a single payment that covers both a charge to the landlord for the use of space in his or her building and for the costs of managing that space. Others have separate payments for rent and for operating costs. Landlords can include rent escalation clauses that increase actual rent, operating cost reimbursements or both.
Rent Escalation Clauses for Actual Rent
Rent Escalation Clauses for Actual Rent are typically structured in two ways. Some leases have clauses that define fixed increases. These can take the form of a percentage, such as a 2% annual increase, or they can be structured as a flat increase, such as having rent go up by 50 cents per square foot per year.
Variable increases are typically tied to an index that tracks the rate of inflation, such as the Consumer Price Index (CPI). The timing of increases can also vary. While many landlords like annual small increases, longer term leases may have larger increases spread out over time, such as a 10% increase every five years.
The Best of Both Worlds
Typically, a rent escalation system tied to the CPI or to another measure of inflation is considered the most landlord friendly. The risk that your company takes in signing one of these leases is that if inflation spikes, your rent could also spike. However, if you are able to combine this escalator with annual caps that limit how much it can go up — such as setting the increase as “CPI, not to exceed 3 percent” — you could get the best of both worlds. In times of high inflation your rent goes up, but not more than the cap. When inflation is low, you end up with little to no rent escalation.
Escalations for Operating Expenses
If you have a “net lease” where you’re responsible for your pro-rata share of operating costs, those expenses will also vary. Frequently, common area maintenance charges, property taxes and property insurance are billed on an annual budget basis. At the beginning of the year, your landlord’s management team calculates an estimate of these costs for the ensuing 12 months. They then charge you your share of those expenses, split out on a monthly basis. At the end of the year, they do a reconciliation and either reimburse you for your overpayments or send you a bill for underpayments. They also do a new budget for the new year and adjust your payment accordingly, usually leading to a rent escalation.
Full Service
”Full service” leases include operating expenses and typically have a provision that allows the owner to justify a rent escalation for operating expense increases. Clauses like expense stops and base years are written to establish a baseline of operating costs so that you can be made to pay an increase over that baseline.
Understanding rent clauses can be a challenging process. Working with an experienced commercial real estate advisor specializing in tenant representation can help to ensure that you have access to the right tools and knowledge to be able to calculate what exposure your company could have to rent increases both in the near- and the long-term. Give us a call at 314-821-0085 or send us an email doug@howardcommercial.net
