Build periodic rent increases into your commercial lease provisions to capture annual inflation and long-term appreciation in rents. In future years, rent provisions will become increasingly important to maintain property value as capitalization rates rise.
Types of rent adjustments for consideration
Landlords have a financial need to protect the growth and value of their capital investment in nonresidential income property. The sole method for maintaining the value of income property from year to year is through rent and expense provisions in lease agreements.
To accomplish this feat, the landlord’s leasing agent anticipates the type of provisions for a lease agreement that will deliver the maximum net operating income for all years during the life of the lease. Applying the care and protection owed the landlord in negotiations will provide the landlord future benefits of rents in line with inflation and demographic appreciation.
Since net income from operations sets value and pricing, attention to any ability to shift future cost increases to the tenant will further enhance future value. Future capitalization rates will play a role, driving values inversely to the inevitably rise in rates.
The three basic types of nonresidential rent adjustment provisions (also known as rent escalation clauses) are:
- graduated rent provisions;
- inflation-adjusted rent provisions paired with appreciation-adjusted rent provisions; and
- percentage lease rent provisions.
Graduated rent provisions
The most common rent adjustment provision used in short-term nonresidential lease agreements is the graduated rent provision. [See first tuesday Form 552]
Graduated rent provisions increase the monthly rent due in the years following the first year’s payment of a base rent. The adjustments are made annually, or sometimes semi-annually. The periodic upward adjustment is either:
- a specific dollar amount; or
- a percentage of the base year rent or rent paid during the previous period.
When setting the rent adjustment amount, be it a dollar or percentage figure, the landlord takes into account:
- expected rate of future inflation, say 2% as now anticipated by the long-term bond market;
- local market conditions, such as expected user demand and scarcity of like properties, demographics of increased density and incomes, traffic counts and infrastructure improvements contributing to property appreciation; and
- the tenant’s evolving use and its burden on the property and improvements.
Rather than being tied to a formal index, the rent increases set by a graduated rent provision are negotiated. No paradigm exists, but increases of, say, 3% can be customary in some markets, as it provides returns to the landlord exceeding inflation.
During recessionary times and recovery stages in a business cycle, graduated rent provisions are popular when the landlord seeks to incentivize tenants to lease vacant space. The landlord agrees to a low initial teaser rent, in addition to a few months of rent-free possession to offset the tenant’s initial relocation costs. The graduated rent provision then bumps up the rent so any below-market rents paid in the early years are picked up in future rents that may even exceed market rates. This is similar to the negative amortization feature in past adjustable rate mortgages (ARMs).
Any up-front, rent-free period needs to be viewed as part of a vacancy and lost rents factor since no rent is received to contribute to gross income. The cost of any tenant improvements (TIs) the landlord pays is recovered by adding the monthly amount of an amortized payment of the costs over the initial term of the lease to the amount of monthly rent a tenant would pay for use of the property before TIs.
Inflation-adjusted rent provisions for purchasing power
Inflation-adjusted rent provisions keep the property’s annual rental income increasing with the annual rate of consumer price inflation. An inflation provision calls for annual upward rent adjustments based on figures from an inflation index, such as the Consumer Price Index (CPI). [See first tuesday Form 552]
The CPI is an index of fluctuations in the dollar price the local population pays for consumable goods and services. Use of the CPI to adjust rents recovers the dollar’s annual loss of purchasing power to pay for goods and services.
The CPI-U is the value for urban consumers, and is the benchmark used to adjust rents for inflation. For simplicity, we’ll refer to CPI-U as just the CPI. The CPI is a widely recognized index, easily understood and inexpensive to administer. The CPI database with select data for your geographic location can be accessed here.
Here are some basic guidelines to follow when using the CPI method:
- set a base rent payable monthly during the first year of the lease, called the “minimum” rent (floor);
- indicate the exact index to be used for the CPI adjustment figures (e.g., the Los Angeles-Riverside-Anaheim CPI);
- indicate an alternative index if the one selected is discarded or altered;
- note the month for the CPI figure to be used to compute annual adjustments; and
- state the month payments begin at the adjusted amount (e.g., anniversary month for the commencement of possession under the lease agreement).
A good practice is to use CPI figures for the third month preceding commencement of the lease to compute periodic adjustments.
But why not use the CPI for the month in which rent is adjusted? When the CPI figure hasn’t been released, which will be the case, the landlord needs to estimate the rent due for the anniversary month. When the CPI figure for the anniversary month is later released and the rent adjustment is calculated, the landlord then needs to account for the rent received beginning with the anniversary month. Using a CPI figure for the third month prior to the adjustment guarantees an actual figure is available with plenty of time to calculate the rent adjustment and advise the tenant of the adjusted rent amount.
Calculating the CPI: Year-to-year CPI adjustment
Under annual rent inflation adjustment provisions, the prior year’s rent and CPI are used to set the adjusted rent. [See first tuesday Form 552 §3.4(c)]
Thus, the year-to-year adjustment formula is:
(current CPI ÷ last year’s CPI) × current rent
Though widely used, CPI only addresses inflation resulting from the Federal Reserve’s monetary policy. CPI is limited to measuring changes in the purchasing power of the dollar as reflected in the prices of consumer goods and services, which include rents. The CPI does not reflect changes in the property’s actual rental value, only in the amount of rent. Thus, to capture both inflation and long-term appreciation in rents, inflation-adjusted rent provisions are often paired with appreciation-adjusted rent provisions.
Appreciation-adjusted rent provisions: local demographics
Rents are also forged by public appreciation for a property’s location, the result of a combination of:
- local demographics (density and income sets demand);
- government investments and programs in the community; and
- supply of available units or space in the local market.
Long-term nonresidential lease agreements need rent provisions which capture the financial benefits these conditions create for property owners (and tenant businesses) over time. To garner the value of evolving local economic conditions, appreciation-adjusted rent provisions are included in the nonresidential lease agreement. Through the provision, rents are adjusted every three to five years to capture any increase in rents brought about by the effect of local appreciation, increasing rents beyond the inflation-adjusted increase in rent.
The longer the lease term, the more likely an appreciation-adjusted rent provision will be negotiated and included in the lease agreement. [See first tuesday Form 552]
The amount of rent increase due to appreciation is determined by a rental market analysis of comparable properties at the time of the rent adjustment. This includes situations unique to the leased property, such as:
- new developments or increased business activity at the location of the property;
- demand for like properties in the immediate area; and
- traffic counts and patterns directly affecting the property, often determined by the location of big anchor tenants.
Again, appreciation-adjusted rent provisions work in tandem with the inflation-adjusted rent provisions. The inflation adjustment is annual; the appreciation adjustment takes place every three to five years.
Percentage lease rent provisions for high traffic sites
The percentage lease rent provision works a little differently from other rent adjustment provisions. While using different formulas for adjusting rent, rent provisions have one common feature – the base rent. The base rent is the minimum rent paid by the tenant to the landlord each month.
Percentage lease rent provisions have a formula for additional rent to be paid separately from the base rent due monthly, called percentage rent or overage rent. Percentage rent due is typically calculated as a percent of the tenant’s gross sales less the amount of base rent paid monthly during the year, a natural breakpoint situation. Percentage lease rent provisions are commonly negotiated with restaurants and retail tenants dependent on high vehicular or foot traffic to drive their sales.
Pairing the base rent amount with a percentage rent formula assures the landlord a full return at the appreciated rental value for the property due to its location. Thus:
- the base rent provides the landlord with a minimum return on investment for the tenant’s use of the property; and
- the additional percentage rent provides the landlord with a return on their investment based on the contribution of the property’s location to the tenant’s operating success.
The additional rent is triggered when the tenant’s gross income from sales exceed a negotiated dollar threshold, known as the breakpoint. The natural breakpoint is the point at which the calculated percentage rent amount for a period, say one year, exceeds the base rent paid during the period. However, landlords and tenants may negotiate a higher or lower breakpoint for the additional rent to kick in than the amount of base rent paid. A lower breakpoint increases the rent the landlord receives.
To determine the formula for additional rent under a percentage lease rent provision, the landlord relies on an estimate of the tenant’s gross sales for the first 12 months of operations, as well as:
- the traffic count and traffic patterns at the location of the premises;
- the dollar amount of anticipated sales and average dollar sales; and
- the price range of the goods and services to be offered.
The landlord then negotiates with the tenant to set the percentage of the tenant’s annual gross sales for calculating the additional rent. With a natural breakpoint (greater than base rent), when the percentage amount exceeds the base rent paid, the tenant pays the excess amount as additional rent.
Percentage rent is typically due within a month or two after the end of the year, when the tenant’s gross income for the period is known. The frequency of the additional rent payment is negotiable, based on:
- whether the tenant’s sales trends are constant or seasonal; and
- the financial strength of the tenant.
Consider a landlord and tenant who agree to a base rent of $5,000 per month, or $60,000 per year. The percentage rent provision calls for the payment of rent equal to 6% of the tenant’s gross income, paid monthly at the base rent amount with the balance due annually. The landlord and tenant agree to a natural breakpoint.
At the end of the year, the tenant has a gross income of $1,500,000. The total percentage rent due is $90,000 ($1,500,000 x 0.06). The percentage rent exceeds the annual base rent by $30,000. Thus, the total rent owed to the landlord for the year is:
- $60,000 in base rent, paid monthly during the year; and
- $30,000 in excess percentage rent, paid within 30 to 60 days after the end of the year.
Operating expense reimbursement
As additional rent, a landlord may negotiate the nonresidential tenant pay some or all of the costs of operating the property, producing various modifications of a gross or net lease agreement. These costs include:
- various operating expenses;
- future increases in operating expenses; and/or
- a pro rata share of the common area maintenance (CAM). [See first tuesday Form 552-3]
CAM provisions obligate the tenant to pay a pro rata share of the costs to maintain the common areas of the property, which may include:
- utilities (water, electric, etc.);
- heating, ventilation and air conditioning (HVAC);
- janitorial services;
- insurance premiums;
- management fees; and
- real estate taxes.
Stay tuned for our new series of nonresidential real estate forms!
For case examples and a more in-depth discussion of the non-residential rate increases, see Volume 4 of the first tuesday Realtipedia, Real Estate Property Management (Chapter 42: Rent provisions in nonresidential leases, Chapter 43: Adjustable rent provisions and Chapter 45: Percentage lease rent provisions). The first tuesday Realtipedia is your premier 16-volume guide for real estate transactions.