How Rent Escalation Clauses Work
In most commercial leases, rents are set to increase over time. How often, and by how much they increase is specified in a lease contract’s rent escalation clause. Rent escalation clauses are essential for commercial landlords, since, if rents did not increase, landlords would not be able to keep pace with inflation. In practice, this means they likely be unable to continue renting their properties due increase maintenance and operating costs.
Rent Escalation for Rent vs. Operating Costs
Rent escalation clauses come in two main varieties, escalation clauses that directly increase rent, and escalation clauses that are tied to increased operating costs. Depending on the lease, this may be combined into one payment, or it may be calculated as two separate payments.
Rent Escalation for Rent
Rent escalation clauses sometimes involve a set percentage increase over time (i.e. 3% increase per year), or, they may include a variable percentage increase, often based on the Consumer Price Index (CPI), an index maintained by the U.S. Bureau of Labor Statistics which measures the average change over time in overall consumer prices over time. CPI-based increases often come with a cap of 3%, which is highly beneficial to tenants.
Set percentage increases, also known as stepped increases, may also increase on a per square foot (PSF) basis. For instance, a property could start at $20/sq. ft. in year one, and may increase by $1/year for each year of a 10-year lease. In this example, rent would increase to $21/sq. ft. in year 2, and would increase up to $30/sq. ft. by year 10. In longer-term leases, especially those which are 20 years or longer, rents may increase at longer intervals, such as once every 3 or 5 years.
Rent Escalation for Operating Expenses and Taxes
The other type of rental escalation clauses does not directly increase a tenant’s rent, but instead increases the amount operating expenses that they reimburse the landlord. For example, common area maintenance (CAM) expenses are often increase each year, and since a tenant is typically billed for their portion of CAM fees, their rent could increase on an annual basis due to this alone. Another type of rental escalation is called tax pass-through escalation, in which tenants pay for increases in a landlord’s property taxes, based upon the percentage of the property that they are leasing.
Gross Leases, Operating Costs, and Rental Escalation
While it’s common knowledge that double net and triple net leases require a tenant to pay their full share of operational and maintenance expenses, gross leases typically cover these expenses in the cost of rent. However, this is not always the case; some gross leases also require tenants to pay for increases in operating costs if they exceed a certain amount, known as an expense stop. Expense stops are typically calculated on a per square foot basis.
Rent Escalation and Lease Renewals
If a lease agreement has an option to renew, this option also typically involves a rent escalation clause. Rents may increase by a specific amount, such as by a percentage or via an increase in rent per square foot, as mentioned above. Alternatively, a lease renewal option could re-adjust the the rent to fair market value, or fair market value capped at a certain percentage increase. Fair market value increases are generally best for landlords, but a landlord may wish to include a more tenant-friendly rent escalation clause in order to induce a potential tenant to sign a lease.