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Rent Escalation Clauses in Commercial Real Estate
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.
- How Rent Escalation Clauses Work
- Rent Escalation for Rent vs. Operating Costs
- Rent Escalation for Rent
- Rent Escalation for Operating Expenses and Taxes
- Gross Leases, Operating Costs, and Rental Escalation
- Rent Escalation and Lease Renewals
- Questions? Fill out the form below to speak with a commercial real estate loan specialist.
- Related Questions
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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.
Questions? Fill out the form below to speak with a commercial real estate loan specialist.
Related Questions
What is a rent escalation clause in commercial real estate?
A rent escalation clause in commercial real estate is a clause in a lease agreement that specifies how often and by how much the rent will increase over time. This clause is essential for commercial landlords, since it allows them to keep pace with inflation and continue renting their properties due to increasing maintenance and operating costs.
SourceHow does a rent escalation clause 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.
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.
What are the benefits of a rent escalation clause?
Rent escalation clauses are beneficial for landlords because they allow them to keep pace with inflation and maintain their properties. Rent escalation clauses also provide tenants with the security of knowing that their rent will not increase drastically, as the clause will specify how much and how often the rent will increase. This can be beneficial for tenants, as it allows them to plan their budget accordingly. Additionally, rent escalation clauses can be used to incentivize tenants to sign a lease, as landlords may include more tenant-friendly rent escalation clauses in order to attract potential tenants.
What are the drawbacks of a rent escalation clause?
The main drawback of a rent escalation clause is that it can be difficult to predict how much the rent will increase over time. This can make it difficult for tenants to budget for future rent payments. Additionally, if the rent increases too much, tenants may be unable to afford the rent and may be forced to move out.
Source: www.commercialrealestate.loans/commercial-real-estate-glossary/rent-escalation-clauses
What are the most common rent escalation clauses?
The most common rent escalation clauses are those that increase rent by a specific amount, such as by a percentage or via an increase in rent per square foot. 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. Rent escalation clauses can also be tied to increased operating costs, depending on the lease.
Source: www.commercialrealestate.loans/commercial-real-estate-glossary/rent-escalation-clauses
How can I negotiate a rent escalation clause?
Negotiating a rent escalation clause can be done by understanding the terms of the lease agreement and the market conditions. It is important to understand the terms of the lease agreement, such as the length of the lease, the amount of rent, and the terms of the rent escalation clause. Additionally, it is important to understand the market conditions, such as the current rental rates for similar properties in the area, the current inflation rate, and the current economic conditions. With this information, you can negotiate a rent escalation clause that is beneficial to both the landlord and the tenant.
For example, you may be able to negotiate a rent escalation clause that increases the rent by a certain percentage each year, or one that adjusts the rent to fair market value. Additionally, you may be able to negotiate a cap on the rent increase, or a rent freeze for a certain period of time.
It is important to remember that the landlord may not be willing to negotiate the rent escalation clause, so it is important to be prepared to negotiate other terms of the lease agreement, such as the length of the lease, the amount of rent, or other terms of the lease agreement.