Rising Escalation Clauses

As the commercial office market begins to show signs of improving, commercial owners and brokers are taking a closer look at escalation clauses when they negotiate new leases.


from Realtors' Commercial Alliance Report

"Escalation clauses, sometimes referred to as pass-through clauses, enable an office building owner to raise rent to cover increases in operating expenses and sometimes property taxes. The value of escalation clauses in protecting landlords from unexpected cost increases is particularly important in today's volatile economic climate.


Rising interest rates and a falling dollar raise the specter of inflation. Higher operating costs, especially for heating oil and gas, are also putting pressure on owners' bottom lines. And the longer the lease, the more exposure and the greater the uncertainty the landlord faces. At the same, landlords must not let their inflation fears become so strong that it costs them tenants. Yet, failing to craft escalation clauses that address current and projected market realities can prove costly.


Fixed increases


Because fixed increases don't reflect actual costs or market conditions either the landlord or the tenant may stand to lose over the course of the lease. Landlords will be particularly hard hit if inflation rises rapidly. However, knowing exactly what the rental amount will be may be comforting to certain, more conservative tenants.


Consumer price index increases


The CPI is usually a closer measure of inflation than fixed increases.
Because CPI increases are applied to the entire base rent, including profit and fixed costs, which are not necessarily influenced by inflation, they usually work to the landlord's benefit. CPI increases are not common except during periods of high inflation, but property owners and managers may wish to begin inserting them in new leases – especially those with longer terms.


Straight cost pass-throughs


This alternative comes closest to achieving the goal of passing through only net increases. This makes it more equitable to both the owner and the tenant. Increases are calculated against costs for a designated base year. It's critical to ensure that the base year is being properly computed when calculating pass-throughs. Owners could be adversely affected if the base year is artificially high because of an unusual repair expense or temporarily high vacancy caused by the move-out of a major tenant. Take care to exclude uncommon expense items from the base year and spell out in the lease how unusual expenses are allocated if they occur in the future. Also be certain to detail how expenses will be allocated to a tenant if there are vacancies exceeding an agreed-upon percentage in either the base year or subsequent years.


Tailored operating cost pass-throughs


One way to make pass-throughs easier to deal with is to escalate only those expenses that tend to more volatile and pass through on an individual basis. The most common of these items are property taxes, utility costs, insurance, repairs and maintenance, and fuel oil.


There is no single answer as to the most appropriate structure for an escalation clause. Building and zoning conditions as well as the future economic environment will certainly influence which method is most advantageous for calculating escalations. But whatever escalation is used, the lease should specify annual reporting requirements so that both owners and tenants can be assured that costs are allocated and billed correctly." For more information see: www.houstonrealtyadvisors.com or www.houstonrealtyadvisors.net