What Is an Escalation Clause in a Lease?
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How Does Escalation Clause in Commercial Real Estate Work?
Most commercial leases have an escalation clause that explains how much and how often the rent will increase during the lease term. Typically, rent escalations happen yearly.
Landlords typically raise rent this way to cover for increases in the costs of running the commercial property over a 10- or 15-year lease term. The rent increase will cover the costs of real estate taxes, insurance, wages of the staff, the security of the property, and the like.
Property values in an area may also rise over time. With rent increases, landlords and commercial property owners can avoid losing profit when signing long-term leases.
The ways the rent will increase varies in commercial real estate lease agreements. Some contracts will increase the rent based on changes in market conditions. Others will require payments for operating expenses, while some will tie the rent increase to changes in the Consumer Price Index (CPI) released by the Bureau of Labor Statistics.
BY THE NUMBERS: A typical rent increase ranges between 2% and 5%. In areas not subject to rent control laws, landlords may increase rents as necessary as long as they give the tenants ample notice.
How Much Does the Rent Increase?
Here are some of the most common escalation clauses used in commercial leases.
This type is common in commercial real estate deals and specifies a set increase in rent over the life of the lease. Typically, this involves small percentage increases every year. For example, landlords may require 1% to 2% increases in rent annually, while others by 5% every two to three years.
With a stepped increase, the rent will rise incrementally every year. Generally, landlords use the commercial property’s square footage to determine the rental rate increase.
For example, the base rent for a commercial property starts at $18 per square foot. The lease contract says that every year, the base rent will be increased by $1 per square foot for a 10-year lease. That means the tenant will pay $19 per square foot for the second year, $20 per square foot for the third year, and so on.
Variable CPI Rent Increase
Also known as indexed rental escalation, this type increases the base rent to keep up with inflation. However, it is tied to the CPI, making it unpredictable.
Generally, the average rent increase based on the CPI is 3% to 4%, but it can increase dramatically during rising inflation. Landlords benefit from this type of rent escalation because they can easily adjust the rent and cost reimbursements.
Tax Pass-Through Rent Increase
A tax pass-through rent increase happens when the landlord’s property taxes increase substantially during the term of the tenant’s lease. The tenant will be required to pay a percentage of the tax increase based on the size of the space that they are leasing.
Direct Cost Pass-Through Rent Increase
Operating expenses—electricity, water, heating, security, and maintenance—may increase during the life of the tenant’s lease. This escalation clause lets the landlord pass on these operating charges to the tenant. In addition, the clause describes which costs are operating costs and how and when rent prices will go up because of increases in these costs.
Lease Renewal Rent Increase
If the lease agreement comes with an option to renew, the landlord may adjust the rent price as part of the new lease terms. This increase may be a fixed amount or calculated per square foot. The landlord may also change the rent price to reflect the fair market value.
Can Tenants Negotiate Rent Increases?
Tenants may seek the help of commercial real estate attorneys to negotiate the terms of a commercial lease agreement. The lawyer may help the landlord and tenant agree on a fair and equitable escalation clause for both parties. Without a limit on the rent escalation, a rent increase may spiral out of control and become too much for the tenant to manage.
A variable CPI rent increase, for example, typically involves a cap of 3% to protect the tenant’s interests and keep the rent manageable during periods when the CPI increases at a faster rate. It is beneficial for the tenant to negotiate a fixed annual percentage increase.
A tenant may also negotiate an upper limit to the rent increases based on operational expenses. For example, the landlord and tenant may agree on a cap on the amount passed on to the tenant when maintenance charges increase from year to year. This way, the tenant can be protected against any significant increase in operating expenses.
BY THE NUMBERS: In California, annual rent increases of 5% plus the CPI, up to 10%, are allowed.
- An escalation clause in commercial real estate is a provision in a lease contract that allows landlords to increase rent. This clause explains how much and how often the rent will increase during the lease term.
- The rent may increase based on a predetermined amount over the life of the lease, inflation trends, rising operational costs, and rising property taxes.
- Tenants may seek the help of a commercial real estate lawyer to ensure that the escalation clause is calculated accurately and fairly.
- Catalano, D. (2020.) How To Navigate Commercial Rent Escalation Clauses. iOptimize Realty. Retrieved from: https://www.ioptimizerealty.com/blog/commercial-rent-escalation-clauses
- Commercial Lease Law Insider. (2019.) Can You Use ‘Escalation’ Clause to Make Tenant Pay Property Tax Increase? Retrieved from: https://www.commercialleaselawinsider.com/article/can-you-use-escalation-clause-make-tenant-pay-property-tax-increase
- U.S. Bureau of Labor Statistics. (n.d.) How to Use the Consumer Price Index for Escalation. Retrieved from: https://www.bls.gov/cpi/factsheets/escalation.htm
- Sher Garner Cahill Richter Klein & Hilbert, L.L.C. (2020.) What is an escalation clause? Retrieved from: https://www.shergarner.com/blog/2020/11/what-is-an-escalation-clause/
- Austin Tenant Advisors. (n.d.) Rent Escalations in Commercial Leases. Retrieved from: https://www.austintenantadvisors.com/blog/rent-escalations-in-commercial-leases/
- The National Law Review. (2021.) Inflation is Back, Should You Consider Consumer Price Index (CPI) Rent Increases in Your Leases? Retrieved from: https://www.natlawreview.com/article/inflation-back-should-you-consider-consumer-price-index-cpi-rent-increases-your
- Schechter. (2021.) Commercial Tenants and the Tax Escalator. HABITAT. Retrieved from: https://www.habitatmag.com/Publication-Content/Legal-Financial/2008/2008-February/Commercial-Tenants-and-the-Tax-Escalator
- Cecil & Campbell Advisors. (2020.) What are Pass-Through Expenses? Retrieved from: https://www.cecilcampbell.com/pass-through-expenses/
- Hand, B. (2021.) What’s the Difference Between a Lease Extension vs. Renewal? Landing. Retrieved from: https://www.hellolanding.com/blog/whats-the-difference-between-a-lease-extension-vs-renewal/
- Legal Nature. (n.d.) How to Successfully Negotiate a Commercial Lease with a Landlord. Retrieved from: https://www.legalnature.com/guides/how-to-successfully-negotiate-a-commercial-lease-with-a-landlord#important-and-often-overlooked-lease-provisions