Rising inflation is influencing virtually every aspect of life. For commercial landlords and tenants alike, it is more important than ever to focus on rent escalation provisions in your commercial lease agreement.
Instead of fixed and consistent increases in rent, some commercial leases provide for rent to increase in line with certain economic metrics: for example, the consumer price index. This is especially relevant as it relates to tenant renewal options. Where inflation is especially notable, as has been the case this year, rent increase formulas that rely on economic metrics to calculate an increase in rent may yield unexpectedly high rent for a commercial tenant, and may result in an unexpected windfall for a commercial landlord. Since the commercial real estate market relies on certain market equilibrium, unexpected or unanticipated increases in formulaic rent may have unintended disruptive market consequences. Focusing on these issues now will help minimize disputes and non-payment for commercial landlords and business risk for commercial tenants.
Negotiating Your Commercial Lease Agreement
For commercial landlords, protecting property interests and maintaining consistent profitability are two focal points when drafting and negotiating a commercial lease agreement. For commercial tenants, managing risk and expense (as well as future increases) is a vital part of negotiating a commercial lease agreement. Inflation and rent escalation clauses go hand in hand – when inflation rises, rents rise along with it. While inflation is not a new economic concept, rising inflation at unusual rates does create unanticipated results.
Clarity on rent and rent increase is an integral part of any lease. Most commonly, commercial leases provide for annual rent increases at a fixed rate. Sometimes, these increases are not annual, but every few years. Where things become more complex is when increases are tied to economic metrics. As we address the four common commercial lease rent structures, it is important to think about these in the context of periods of high inflation.
Common Forms of Rent Escalation
- Fixed Increases (also known as Stepped or Percentage Increases) allow landlords to increase rent by a set amount at specific points in the duration of the lease agreement. This is one of the most popular options because it is a relatively straightforward method. However, a landlord may feel cheated out of profits if costs have gone up and a tenant may feel like they lost out on potential savings if costs have gone down.
- Pass Through Escalation is a form of rent escalation that is initiated only when the landlord experiences an increase in costs that have been specified in the commercial lease agreement. This is most common in scenarios where a commercial tenant is responsible for compensating landlord for building operating expenses.
- Direct Operating Cost Escalation is similar to the Pass Through option, except here the escalation is based on the increases of all the operating costs such as utilities, security, and maintenance.
- Indexed/Variable Escalation (Consumer Price Index or another inflation index) – This option allows landlords to increase rent when an established index rises. Often, a cap will be included on how much the rent can go up in a year. This option is not favorable to tenants because index increases can be very unpredictable and dramatic.
Understanding the various rent escalation options is critical for commercial landlords and tenants negotiating new leases.
For existing leases that have rent escalations tied to inflation risk, it is critical to understand how the current economic environment will impact future rent. A common issue is whether a commercial tenant should exercise a right it may have in the lease to renew. Often, tenant renewal options provide for rent to be calculated using market metrics. Conceptually, this generally works well where the economic environment is stable and inflation is low. In such cases, the formulaic rent escalations adjust the rent to where the market suggests it should be and mostly everyone is satisfied. However, in situations where the economic market is unstable and inflation is especially high, the formulaic rent escalations could adjust the rent to extreme amounts not expected by landlords or tenants. For tenants, this could create an increase in rental expenses beyond what may been budgeted or sustainable by the business. For landlords, this could create scenarios where multiple tenants are unable to afford the drastically increased rent, leading to higher rate of default.
Ultimately, by highlighting and focusing on the impact of inflation on commercial rent increases, our goal is to shed light on this critical but often overlooked legal and business issue.
Here at CMM, we help clients – whether they are landlords or tenants – navigate how to structure the commercial lease agreement and the rent escalation provisions. We would be happy to help businesses navigate their existing leases to assist with making sound business decisions in light of existing rental escalation framework.
Please contact us to discuss options.
Thank you to Ashley Cohen, Esq. for her contributions to this article.