January 3rd, 2014, By Don Catalano
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:
Tenants must insert understandable and precise language in the escalation provision. The clause should make it clear to both parties of the agreement that a specific index will be used to calculate the rent increase on an agreed base lease date.
For example:
“The Consumer Price Index for all Urban Consumers will be used to calculate the rent escalation each calendar year. The landlord will use the most recently published CPI (at the time of the rent increase) to the specified base lease date.”
The base lease date may be the first day of the first month of the lease agreement, time of possession, date of prior calculations or other base lease date as agreed to by the parties.
Obtain a clear understanding of the publishing schedule for the index used in the computation. This is important because if the base lease date is December 1st, the index for that month may not become available until mid-February the next year, thereby necessitating the use of the index published the preceding October.
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.
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 relationship 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.