Commercial leases can be very complicated and it’s critical that you have a clear understanding of the different elements in the lease.
In the following section, I have provided an explanation of escalations and how they are calculated.
For commercial office Tenants, the relationship with a Landlord extends beyond the initial lease transaction. The Tenant incurs expenses and contracts with the Landlord for services, including construction, cleaning, electric service, air conditioning, heat, security and maintenance.
Escalations are clauses in the lease that provide rent increases to cover property operating costs and real estate taxes. These clauses are required by mortgagees in order to secure the mortgage and prevent the net income and equity in the property from decreasing. There are several forms of escalations commonly used: direct expense passthrough; CPI (consumer price index); set percentage increases; and Porter's Wage Formula (New York City only).
Direct Expense Pass-Through
This is the most favorable approach for the Tenant, given proper checks and balances. Under this clause, the Tenant pays the increase in expenses calculated over a base year. The base year is usually the first year of occupancy or a mutually agreed upon year. The expenses for the base year are fixed. In the years subsequent to the base year, the Tenant pays its share (as a percentage of the building) of any increases in the annual operating expenses. For example, if a Tenant occupies 20,000 square feet of a 100,000 square foot building, or 20% of the building, and the expenses for a building are $400,000 in the base year and $412,000 in the following year, the Tenant would pay an additional $2,400 per year ($412,000-$400,000 X 0.20). In subsequent years, expenses are compared to the base year and multiplied by the Tenant's proportional share.
A Tenant should be aware of what constitutes "expenses." As a general rule, any type of capital expense is excluded from the category of operating expenses. Lease terms should insure that expenses are within an acceptable range for similar properties. In addition, the Tenant should have the right to audit the Landlord's accounts. It is very important to verify base year expenses to ensure that they are not substantially lower than subsequent years. In addition, Tenants pick up the entire cost of additional services if they are provided in subsequent years.
CPI Increases
Rental rates are based on the increase in the Consumer Price Index (the "CPI"). If a rent is $20 per square foot and the CPI increases by 2%, the rent in the subsequent year is $20.40 ($20 x .02). The CPI is cumulative. In this example, if the third year increase in CPI is 3%, the cumulative increase is $20.40 + ($20.40 x .03,) resulting in a per-square-foot rent of $21.01. If inflation increases at 5% per year, cumulative increases result in a $31.03 final rent for a ten year lease with a $20 beginning rent.
The US Department of Labor has established a number of ways to measure inflation. Be aware of the index used, as some rise faster than others.
Set Percentage Increases
These are calculated in the same manner as CPI except the Tenant and the Landlord agree in advance on the annual increases. For example, the parties may agree on an annual increase of 3% per year, which may be cumulative.
Porter's Wage Formula
This method is peculiar to New York. It was developed as a proxy for Landlord's costs. The idea is that as wages for building porters increase as a result of collective bargaining, the increases create an overall increase in the operating expenses for the Landlord. The increase is then passed on to the Tenant. While the mechanism varies, the most common scenario is as follows:
Landlord and Tenant agree that as the Porter's hourly wage, which results from a negotiation between the Realty Advisory Board (Landlord's bargaining agent) and the local union, increases for Class A office buildings and for worker classification designated "Other", the per square foot rental rate increases by the same amount. For example, the worker's hourly wage increases by 60 per hour the rent shall be an additional 60 per square foot. It becomes more complicated if wages include the hourly value of fringe benefits. Information on the past and prospective increases in Porter's Wages can be found in the Real Estate Board of New York Diary. (See www.rebny.com/useinfo.html).
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