One of the reasons that real estate is such a great investment is that it offers inflation protection in the form of annual escalations to the base rent over the term of the lease. Increases in the costs of ownership, i.e. operating expenses, real estate taxes, etc. are also passed along to the tenant (discussed in greater detail in What Are Pass-throughs?).
Tenants must consider the impact of annual escalations when making leasing decisions. For example, if a tenant thinks that market rates will not increase (on a percentage basis) by more than the rental escalation they may prefer a shorter lease term (5 years vs. 10 years) with renewal options so that they can renegotiate their rent to the then market rate at the expiration of their initial lease term.
So, when it comes to annual rental escalations, what’s market? The most commonly used escalation is 3%.
Rent escalations, like most terms, are subject to negotiation. For leases with smaller square footages and/or lower rental rates the impact of the annual escalation is minimal. In the case of larger spaces with high rental rates though, negotiating a lower escalator can result in significant savings over the lease term.
Annual escalations can be negotiated to lower rates, i.e. 2% or can be tied to an index like the CPI. In requesting the escalation be tied to an index the tenant is making a gamble that the index will increase by less than the initially proposed amount, which may not be the case.
In other cases, tenants may be able to negotiate a stepped rental schedule and/or no escalations for a set number of years. In the case of a stepped rental schedule, a tenant may negotiate a below market rate at the beginning of the lease term that will increase by a higher percentage annually or by set amounts in subsequent years for the purposes of keeping their rental obligations artificially low as they business grows. Another possibility is to negotiate no increases for a set number of years with the rent escalating at the end of that time by a predetermined amount. That predetermined amount could simply be the market escalation, i.e. 3% annually or compounded over the years in which there were no escalations. For example, if the market escalation is typically 3% a tenant could negotiate no increases over the first 5 years of the lease with the rent escalating by 15% at the beginning of year 6.
Finally, another less used option would be to average the rent over the term of the lease and negotiate a fixed rent over the term. The landlord would realize benefits on the front end of the lease with the tenant benefiting on the back end. For example, if a tenant is leasing space for 5 years with a base rent of $20.00/sf/yr with 3% annual escalations the rent would be $22.51/sf/yr in year 5. The average rent, however, would be $21.24/sf/yr. In year 1 of the lease the tenant would be paying $1.24/sf/yr more but in year 5 would be paying $1.27/sf/yr less. While uncommon, this structure provides consistency on a tenant’s balance sheet.
As always, when negotiating lease terms it’s recommended to seek the advice of a commercial real estate professional. For more information, questions, or representation services please contact Ryan Rauner at firstname.lastname@example.org or 703-943-7079.