This article discusses the various adjustable rent clauses used in nonresidential leases.
Economic goals of nonresidential landlords
Rent works to provide a yield on an investment in real estate, as does dividends and interest on stocks and bonds. A lender receives interest for the use of money lent for a specific period of time. Likewise, a landlord receives rent for the use of property let for a specific period of time.
At the end of the respective right-to-use periods, both the money and the real estate are returned.
Like interest provisions in a note, rent provisions in a nonresidential lease agreement should anticipate future market changes that will affect the investment (value, income, expenses and debt) by structuring the rent provisions to conform the rent income to match the anticipated changes.
Fixed-rent leases do not anticipate future changes in the investment’s fundamentals. However, variable or adjustable- rent leases do anticipate changes negatively affecting the owner’s net operating income or spendable income, unless shifted to the tenant by way of an equal increase in rent.
Types of adjustable rent
The three basic types of rent adjustment provisions found in nonresidential leases, sometimes called rent escalation clauses, are:
- graduated rent provisions;
- inflation adjusted rent provisions; and
- appreciation adjusted rent provisions.
The economic goals a leasing agent must review with his nonresidential landlord-client when negotiating provisions for future rents include:
- adjustments for the lost purchasing power of the dollar due to future price inflation;
- adjustments in rent to reflect the rate of appreciation on comparable properties (beyond the rate of inflation); and
- the absorption or pass-through of increased expenditures for operating expenses and interest adjustments on mortgage debt.
To protect the property’s income, and in turn its value, against a loss in the US dollar’s purchasing power due to inflation, rent can be periodically adjusted based on a price inflation clause in the lease agreement. An inflation clause calls for periodic rent increases based on figures from an inflation index, such as the Consumer Price Index (CPI) or the Cost of Funds Index.
Further, and to attain rents which reflect an increase in the property’s dollar value brought about by local appreciation, rent can also be adjusted periodically (for example, every three years) to rent amounts received by comparable properties.
Also, increased operating and ownership costs can be absorbed directly or indirectly by the nonresidential tenant by passing on the responsibilities for:
- all the operating expenses, or only future increases in the expenses, by including a clause calling for the tenant to pay specific expenses; or
- a pro rata share of common area maintenance expenses (CAMs), property taxes and hazard insurance premiums.
Future increases in the cost of carrying debt on the property due to variable interest rate mortgage financing can also be passed on to the tenant as increased rent to provide the landlord with a triple-net or pure-net lease.
With knowledge and understanding about the economic and financial consequences of the terms submitted by a tenant in an offer to lease or letter of intent (LOI), the landlord can make an informed financial decision whether to accept, counter or reject the tenant’s offer to lease.
Graduated rents from year to year
Rents bargained for during periods of high vacancies and few prospective tenants are often below market for the initial year or two of a lease, comparable in purpose (and timing) to the initial teaser or qualifying rates for adjustable rate loans (ARMs) and graduated payment loans (GPMs).
Likewise, a graduated rent clause increases the initially low, monthly rent semi-annually or annually in pre-set increments. The amount of the periodic upward adjustment is set at a specific dollar amount or a percentage of the initial rent or rent paid during the prior period.
Graduated rent adjustments are not determined by use of index figures or formulas dependent on data from other sources at the time of the adjustment. The rent amounts are negotiated and set on entering into the lease agreement.
Also, any below-market rents paid in the early years are often picked up in future rents that will exceed market rents, as though the lease had a negative amortization feature taken from ARM loans.
For example, the base monthly rent might be increased, or graduated, each year on the anniversary of the lease by:
- a pre-selected dollar amount; or
- 5% of the base rent set forth in the lease agreement for the first year.
A graduated payment provision with annual rent increases can also be structured based on a percentage increase over the prior year’s monthly rent, a compounding of rents.
For example, the monthly payment during the last year of a graduated payment plan would become the base rent for annual CPI inflation adjustments to set rates annually for the remaining term of the lease.
Future rent increases after the graduated rents have reached the projected market rent amount will be set under a price inflation clause.
Percentage rents and the base rent
Now consider a tenant operating his business in a premises under a percentage lease. The base rent is a fixed monthly dollar amount during the first 12 months of the lease.
The calculations for the alternative minimum annual rent is set at 7% of the tenant’s gross sales. The tenant will pay a total rent equal to the greater amount of the base rent or the alternative percentage rate.
The landlord and tenant also agree the base rent for each year will be increased by 2% of the base rent for the previous year, called a compounded base rent. Alternatively, the base rent could (and should) be increased by agreement at the rate of inflation which took place during the period prior to the adjustment. A price inflation adjustment to the base rent increases the floor for the least amount due as rent each year.
Thus, the annual adjustment to the base rent provides a floor rent for a minimum rate of return on the landlord’s investment throughout the lease term should the tenant’s business suffer a downturn or a drop in annual gross receipts.
Price inflation adjustments
To annually adjust the base rent to compensate for price inflation due to the dollar’s continuing loss of purchasing power, a price inflation clause or CPI clause can be included in the lease agreement.
Inflation adjustments are usually made on each anniversary of the commencement of the lease. Adjustments are based on the annual percentage change in figures from the CPI for the region in which the real estate is located.
The CPI clause can be used to establish the annual rent adjustment in one of two ways:
- a base-year to current-year increase; or
- a year-to-year increase for a compounding effect.
The unpredictable cyclical movement of future price inflation both lulls and infuriates landlords. Thus, for landlords, the rent inflation clause should be boilerplate in every lease running for a period of more than three or four years — if the competitiveness of the marketplace allows for its inclusion.
Occasionally, landlords will ignore the CPI as a basis for inflation adjustments and use a set annual percentage increase of 3% or 4% in its place, which of course is back to graduated rent schedules in an effort to either out-guess or exceed inflation rates.
Periodic appreciation adjustments
If the CPI is the only rent adjustment provision used by the landlord over the life of a long-term lease, the landlord risks loss of any increase in rents in excess of the CPI that is enjoyed by comparable properties, called appreciation. The same risk of lost rent increases for appreciation exists when exclusively using graduated rent clauses (which tend only to cover inflation).
Value increase by appreciation is a local phenomenon, not a monetary one as is inflation. To reflect rent increases brought about by local rental market conditions, the landlord should consider a clause calling for periodic rent adjustments that increases the rent to meet current market rates, called an appreciation or fair market rent clause.
To make the rent adjustment, the base monthly rent is, as agreed-to in the lease, adjusted to a reasonable amount by the landlord every three to five years to reflect local market trends in comparable properties, or as otherwise agreed for adjustment by appraisal in the appreciation clause.
Thus, a lease agreement containing both an inflation clause and an appreciation clause assures the landlord will receive:
- an annual inflation adjustment increasing the amount of rent paid during the entire term of the lease to maintain the purchasing power of the rent amount received at the inception of the lease; and
- a periodic adjustment in the amount of rent to reflect any future increases in rents for comparable properties exceeding the rate of inflation.
A provision can be included in the lease agreement for an appraisal process to set the amount of the appreciated rent if the tenant is concerned about his remedies if the amount set by the landlord as the appreciation adjustment is considered unreasonable.
Setting fair market rents
Consider a nonresidential lease agreement with a use provision calling for the tenant to operate a movie theater on the premises for ten years.
The lease agreement contains a rent appreciation clause stating the landlord will adjust the base rent in five years to reflect the then current fair market rent.
At the time for the appreciation adjustments five years later, the landlord determines the fair market rent for the property by using rent amounts received by comparable properties put to higher and better uses than a movie theater.
The tenant disputes the amount of the adjusted rent demanded by the landlord.
The tenant claims the fair market rental value of the premises should be based on the present use of the property as intended by the lease, since the lease agreement does not provide for the landlord to adjust the rent to reflect a return on the fair market value of comparable properties that have been put to a higher and better use.
Here, the lease agreement states the tenant will use the property to operate a movie theater for the term of the lease. Thus, the rent can only be adjusted to reflect the fair market value of the property based on its use as a movie theater. [Wu v. Interstate Consolidated Industries (1991) 226 CA3d 1511]