What Is a Graduated Lease?
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How Does a Graduated Lease Work?
Under a graduated lease, the landlord (lessor) and the tenant (lessee) sign an agreement stipulating that the lease payments may change over its term, usually in increasing increments.
Rent increases may be tied to an index or an increase in the property’s value; rent may even increase periodically (as the agreement allows) without any external factor. The agreement typically covers how much the rent will increase when it increases and the frequency of the increase. Commercial real estate often employs graduated lease agreements to keep up with property appreciation and market conditions.
Many businesses also arrange graduated leases on a seasonal schedule. Property owners may implement higher rents during peak season, regardless of any changes in market value.
A graduated lease example: a landlord and tenant agree to planned adjustments in monthly rental payments. The tenant signs a 10-year lease, provided they pay $1,700 monthly for the first six months, $1,950 monthly for the six months after that, and $2,200 monthly after two years until term.
What Causes a Rent Increase in a Graduated Lease?
Triggers for rent increases in a graduated lease are due to clauses in the lease agreement. The following are the most common.
An escalation clause (also known as an “escalator”) refers to an increase in the monthly lease payments based on factors such as market conditions, increased property taxes, and even lease renewal. Typically, lessors implement these rent increases annually. Most states establish a cap on how much the rent can go up in a single year.
Landlords may choose to reappraise the property yearly, and a reappraisal clause allows the landlord to increase the rent after such an appraisal. Certain commercial property leases require that the rates be adjusted every three years based on an independent property appraisal. As the value of the property rises, so does rent.
A participation clause requires the lessee to pay their share of increases in maintenance, utility charges, property taxes, and other operating expenses. This clause allows the landlord to pass along the extra costs to a tenant. The rate hikes in a participation clause can be limited by an expense stop provision.
A step-up clause allows for predetermined increases in rent, with or without an external trigger. Both parties agree that rent will be increased by a set amount at specific periods. For example, a tenant or lessee may be required to pay a 5% increase each year over a seven-year term.
Pros and Cons of a Graduated Lease
A graduated lease may benefit both a landlord and a tenant, but not at the same time and not under the same circumstances. While this contract allows lessees to save money upfront, lessors can use their property as a hedge against inflation and other real estate-related expenses.
Lessors also benefit from graduated leases in the long term because real property values appreciate. This lease allows them to charge more rent as the value of the property rises. Lessees pay fair market rent regardless.
Meanwhile, lessees benefit from this type of lease in the short term because they get the property at a discounted rate. Many start-ups tend to enter into this type of lease agreement in order to have more leeway in raising capital.
The main argument against a graduated lease is unpredictability. There is no guarantee a business owner will generate the revenue needed to cover escalating yearly fees. While short-term payments offer a good incentive, the rate hikes over the life of the lease might prove unsustainable in the event of a market downturn or any number of unforeseeable situations.
What Are Other Types of Leases?
A graduated lease is a subtype of what is called a variable lease, where lease payments change (generally increasing) over the term of the lease. Here are other common types:
A gross or full-service lease requires the tenant to pay a fixed monthly base rate. The payment typically covers property taxes, utilities, insurance, common area maintenance, and other operational expenses. As a result, gross lease agreements have higher rental rates compared to other types of leases.
Lessees may negotiate a modified gross lease to limit the property expenses they must cover.
This type of lease requires the tenant to pay base rent plus a proportionate share of the property’s operating expenses, including utilities, taxes, insurance, and common area maintenance. The base rent is typically lower than that of a gross lease.
There are three common types of net leases:
- Single net lease. This net lease charges lessees base rent and utilities plus their share of property taxes. Landlords are responsible for paying maintenance and insurance premiums.
- Double net lease. This net lease charges lessees base rent and utilities plus their share of property taxes and insurance premiums. The landlord only covers maintenance fees.
- Triple net lease. This net lease charges lessees base rent and utilities plus their share of property taxes, insurance, and common area maintenance. In other words, the lessee pays for all property-related expenses.
This lease requires the tenant to pay a base rent plus a percentage of business sales. A percentage lease typically comes with a lower rent in exchange for sharing profits with the landlord. This arrangement is common in retail establishments.
- A graduated lease is a variable lease that allows rent to increase periodically or due to a predetermined external factor, like a consumer index.
- There are several ways to trigger increases in rent in a graduated lease, including an escalator or index clause, a reappraisal clause, and a participation clause.
- Graduated leases can benefit both lessor and lessee, but in different ways. A graduated lease is a hedge against inflation (for the lessor), while the lessee can take advantage of a discounted lease at the start of the term while they are building capital or cash flow. The biggest drawback is overcoming unpredictability within the markets and other external factors.
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