David L. Willis, a Principal with Cresa-Partners Orange County, likes to cite this example of overlooking a very important lease consideration:
“Your broker has found the perfect office suite in a beautiful building close to your home. The asking rate and the parking charges seem reasonable, and the listing broker tells you that he can improve the space exactly the way you want. Things are looking good.
“You tell your broker to prepare a Proposal to Lease, and serious negotiations begin. Invariably, one component that gets very little attention will have a serious impact on several economic issues later on. What is that overlooked component? It is the escalation of rent over the term.”
Smart Business talked with Willis about the dangers of neglecting to consider escalation of rent in your lease negotiations.
How is a base lease rental increased over the term?
Typically, the increase is based on local practice. A market consensus is reached at some point in time and every landlord soon jumps on the bandwagon.
Right now, in Orange County, commercial property-owners are looking to achieve 3 percent to 4 percent annual increases or possibly fixed-amount increases ranging between $0.05 and $0.10 per square foot per month. Today, every proposal changing hands has a rental escalation along these lines.
What other means are used to increase rent?
Over the last 25 years, Orange County brokers have seen flat five-year rates, single mid-term increases and even Consumer Price Index-based increases. The point is, the current market standard for annual increases is not set in concrete. It is negotiable and should be negotiated.
Consider the following example. Your initial rental rate is $2.50 ‘full service gross’ (meaning that taxes, utilities, maintenance and insurance are included in the rate and any increase in those costs will be passed through to you each year). The landlord proposes a 4 percent increase each year of a five-year term. The common argument for needing a rental increase is to account for the erosion of the landlord’s profit due to inflation. That seems reasonable and fair. In reality, the 4 percent increase jumps the base rent from $2.50 to $2.60 in the second year. The landlord’s profit is actually only a fraction of the total lease rate. The profit percentage is determined by deducting debt service, operating expenses, reserves for capital replacements, amortized expenses (such as tenant improvements and broker’s commissions) and overhead from the lease rate. Since the operating expense increases get passed through to the tenant each year and the debt service and the amortized expenses are typically fixed over the term, the rate increase goes solely toward overhead, profit and reserves. A 4 percent increase in your rental rate may result in a 60 percent to 100 percent increase annually in the landlord’s overhead and profit.
But wait: it gets worse. This increase compounds itself. At the end of the five-year term, the lease rate will be $3.04 FSG. The total $0.54 increase over the initial lease rate will provide the landlord with a huge increase in overhead and profit. The problem arises because the inflation-busting increases are being applied to the total lease rate, not just the landlord’s profit percentage. Landlords will argue until they are blue in the face that the 4 percent annual increase is absolutely necessary. Now you know better.
What other lease components are affected by rate escalations?
The security deposit is typically based on the value of the last month’s rent or even 110 percent of the last month’s rent. Obviously, compounding the rent every year by a fixed percentage will make that number much larger than it probably needs to be.
Another problem arises if you have a renewal option with the nasty little phrase, ‘In no event shall the lease rate during the extended term be less than the lease rate being paid during the last month of the initial term.’ It doesn’t take a genius to figure out that those innocent little rent increases may now place your renewal rate well above current market rates. Your option just became worthless and you have to enter into open negotiations as a captive tenant.
Is there a reason to segregate monthly line items?
Yes. You may have had the cost of some above-standard tenant improvements amortized over the term of the lease at the landlord’s cost of funds. That amortized amount frequently gets added in with the monthly rent figure. If only the base rent gets escalated, then you are fine. If they escalate both the base rent and the amortized improvements, it will result in a big windfall for the landlord. You always need to segregate those monthly line items.
DAVID L. WILLIS is a Principal with CresaPartners Orange County. Reach him at firstname.lastname@example.org or (949) 706-6621.