Structuring Leases in Volatile Times

Even in a difficult economy, when landlords are resorting to concessions and cutting rents to fill space, the lease negotiation still must look to the future. When landlords and tenants negotiate lease terms, there are many variables that merit consideration. After agreeing on items such as rental charges, term of lease, tenant improvements and building operating procedures, another highly important item remains that is often overlooked or not properly analyzed.

In an effort to keep their net income constant, landlords naturally want to increase annual rent in order to recover escalating real estate operating costs. What must be considered in order to arrive at a mutually agreeable methodology? After negotiations over lease terms, the escalation clause is often given little thought but can prove to be a costly oversight for either the landlord or the tenant.

Below is an analysis of six methods of escalation:

  1. Fixed increases: Since any relationship to actual cost increases is purely coincidental, either the landlord or the tenant may stand to unfairly lose by adhering to fixed increases.

  2. Percent of increase in tenants' sales (retail space): Since inflation or an increase in costs is only one element in the determination of a tenant's sales volume, either side may get hurt. If a tenant does poorly for reasons besides the economy or location, the landlord does not see any increases, even though costs may be on the rise.

    If a tenant's sales increase is due to factors other than price or normal increases in volume, the tenant may suffer if sales increase due to lower prices and gross margins. The decision on the base sales number can be critical.

  3. Porter wage formula: This formula, which is based on the increase in hourly labor cost for a union porter, usually works to the landlord's benefit in times of high inflation; it's not usually found in leases when inflation is low.

    The increase in wages may or may not be directly related to inflation and cost increases but, under this formula the entire percent increase is applied to total base rent. The formula usually does not even consider the fact that employee head count might have decreased.

  4. Consumer Price Index increases: While a closer measure of inflation in a particular geographical area, it also usually is only found in leases when there is high inflation and usually works to the landlord's benefit. The change is applied to the entire base rent, including profit and costs, which are not necessarily influenced by inflation.

  5. Operating cost pass-through: This comes closer to achieving the goal of only passing through increases in landlord costs. However, it should be noted that all cost items that are included therein are netted, so if certain costs rise and others go down, the landlord is forced to offset.

    Also, the landlord or tenant might be hurt if the base year, from which variations are determined, is artificially high or low. This occurs due to extraordinary expenses in the base year, i.e., repairs and maintenance, vacancies not accounted for or unusually high or low payroll.

    Additionally, if certain items such as property taxes, fuel costs or insurance are included in the pass-through as part of the total, a particular year might be artificially high or low due to an unusual event, such as a property tax retroactive reduction or special insurance premiums.

  6. Operating cost pass-through with certain items mentioned above being passed through separately: This reduces the possibility of having to offset, but does not address the considerations that must be given to the base year. Decreases under any methods of escalation aren't usually passed through to the tenant.

There is no single answer as to the most appropriate structure for an escalation clause. Building and local conditions as well as future economic environment and events certainly influence the impact. The landlord and tenant have a business obligation to understand what the alternatives are assuming various scenarios.

The determination of base year and subsequent year amounts should be carefully spelled out in the lease — i.e., cash, accrual, tax. The lease should specify annual reporting requirements, including if reports are to be audited or reviewed by an independent certified public accountant. Items that will not be included in any base or subsequent year amounts, such as improvements, should be specifically identified and defined.

Gerald Marsden ([email protected]) and Robert Demmett ([email protected]) are partners with the certified public accounting firm of Eisner & Lubin LLP.

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