Rent escalation is a pre-negotiated lease clause in which a tenants base rent is increased on an annual basis.
Rent escalation clauses in commercial leases are negotiable however landlords push for this for two reasons
- To keep up with inflation
- Increase revenue and the commercial property’s value
When leasing commercial real estate for terms longer then 1 year you will typically see rent escalation clauses throughout the lease contract. Below are a few types of rental escalation clauses typically used.
Stepped Rent Escalation Clause
The most common stepped rents are increases by a negotiated dollar amount each year. For example, let’s say your first years base rent is $20 sf. In years 2-5 your base rent is increased by $0.50 each year. It depends on the market you are in however in most cases annual increases will be anywhere from $0.50 to $1.00 sf.
Stepped rents are useful when a tenant needs to conserve cash during the first couple years of their business and needs a lower rent amount. The landlord may have lower cash flow at first however they will recoup that in the later years. In a strong market you will see yearly increases regardless.
Consumer Price Index ( CPI) Rent Escalation
In this situation, the landlord wants to make sure their base rents are keeping up with inflation. Rents will be escalated according to the Bureau of Labor Statistics CPI index. In recent years the average is 3% to 4% however during times of high inflation they can sky rocket. The key here for a tenant is to negotiate a fixed annual percentage increase. That way if the CPI increases at a faster rate you are protected. An open ended CPI increase is more beneficial for the landlord as it protects them from rent erosion during times of inflation during soft markets.
Operating Expense Increases
Operating expenses are the taxes, insurance, and maintenance charges for the property that are typically passed on to Tenants. You may see leases structured as Base Year or NNN (Triplenet) leases.
Operating expenses are “estimated” each year based on historicals. At the end of the year landlords will reconcile their books to determine their actual operating costs. In a NNN lease Tenants will be charged operating expense costs that exceed the original estimates. In a base year lease the tenant will be charged the amount that exceeds their pre-negotiated base year expense stop.