With the exception of short-term commercial leases, nearly all other 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 an 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 commercial lease can use a combination of these methods. Most leases use the fixed amount calculation followed by the CPI. 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.
Here are some concepts to consider when using the CPI or other index to evaluate rent escalation in your commercial lease.
Use Accurate Language in the Agreement
Tenants must insert understandable and precise language in the escalation provision. The clause should make it clear that parties of the agreement agree to use a specific index to calculate the rent increase for an agreed to base lease date.
"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. The reason being, if the base lease date is December 1 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.
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:
Exclude costs that are not reimbursable to the landlord
Adjust bases and expenses to prevent unreasonable 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 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 agreed to by you and the landlord, it important for the sake of your operations and profitability to weigh all factors to prevent excessive rent escalation.
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