The Fishy Side of Fixed Annual Base Rent Percentage Escalations

Sometimes we get more than we bargained for. This can be good, as with the recent “Linsanity” hitting the New York area.

As you can imagine, it is not good for a tenant to find that the rent escalations under its lease are more than was bargained for and larger than expected.

Unfortunately, rent increases under lease escalation clauses often remind me of one of my favorite books that I remember as a child and read with my kids: A Fish Out of Water by Helen Palmer Geisel. This is a story about a boy who does not listen to the pet shop owner’s warning not to feed his new fish too much and the fish outgrows its bowl, a pot, the bathtub and, pretty soon, everything else.

If you are not careful, you may find that your guppy of a rent escalation can also grow into a bit of a whale.

Tenants under most office and retail leases pay a base rent that includes in theory an aggregate of the landlord’s costs to operate the building plus profit. These leases require that the tenant pay their share of the increases in such operating costs during the term of the lease. The purpose is to allow the landlord to retain the same profit under the lease over the term.

As it turns out, escalation provisions are all imperfect in some way. In prior years, leases often provided for increases tied to the consumer price index (which does not necessarily correlate to increases in operating expenses) or the union wages of porters in the building (which not only does not correlate, but is also a huge profit center for landlords).

Modern lease escalations are most often tied to actual increases in the particular building’s operating expenses, although the negotiation over what constitutes “operating expenses” and how these expenses should be billed can be time-consuming (and mind-numbing). There is also a huge potential for landlord shenanigans, even with tenant audit rights.

An escalation tied to fixed annual percentage increases in the base rent (often between 2.5% and 3%) is coming into greater use because it avoids the brain damage (i.e., time and expense) to negotiate and later calculate the operating expense escalation and affords the added advantage to each party of certainty and a quicker, more pleasant lease negotiation.

But is there something fishy about these fixed annual base rent percentage escalations?

Actually, yes. These increases are another example of landlords angling for a substantial profit center.

Landlords will often point out that actual operating expenses on the average increase by the same 2.5% to 3% per year, but when we fillet the numbers we see that the escalation is being calculated on the gross base rent, not just the portion attributable to operating expenses.

For example, the base rent may be $50 per rentable square foot, but the portion of that $50/rsf allocable to operating expenses for a New York City office building is generally estimated to be between $13/rsf and $18/rsf. Not to carp on this point, but the landlord also gets its 2.5% to 3% increase on the $32/rsf to $37/rsf not allocated to operating expenses.

Is this fair? No. Can the inequity be rectified? Possibly.

But a tenant would have to have a fair amount of leverage to tackle this accepted practice. Most tenants with that kind of leverage (i.e., larger tenants) have operating expense escalation provisions based on actual increases, not fixed annual percentage increases. But even though they may have other fish to fry, all tenants should be aware of the inherent inequity and should not feel constrained to push to make these escalations as fair as possible in other regards.

Make sure to cover the following four points when negotiating any fixed annual base rent percentage escalation.

And remember, since these points address the base rent under your Lease, they should all be raised at the term sheet stage or will be much harder to obtain later on.

1. Many leases will include a fixed rent “bump” after a certain period of time (e.g., a ten year lease will often include an increase in the base rent after the fifth year). You should take the position that this is not appropriate in a lease that already includes such built-in profit for the landlord.

2. Notwithstanding the amount of “free rent” or abatement that you receive as a tenant inducement, the first percentage increase in base rent should occur on the one year anniversary of the rent commencement date, not the commencement date. That way you have a full 12 months at the lowest rate (e.g., if your lease provides for a six month rent abatement at the beginning of the term, the first fixed percentage increase should not occur until after the 18th month). This is particularly true when the lease term is extended to incorporate the abatement period.

3. Although perhaps obvious, the Lease should specifically provide that the fixed percentage increases are in lieu of any other operating expense escalation.

Many leases will try to break out and hook you for increases in specific operating expense components notwithstanding that the fixed percentage increases were intended to replace all other operating expense escalations. Energy cost escalations are common, particularly during times of fluctuating oil prices, and recently some leases have even included separate charges for capital expense increases that are typically included in operating expense clauses (e.g., capital expenses incurred in order to comply with subsequently enacted requirements of law or capital items intended to reduce operating expenses). Since you bargained for certainty and are paying a premium, you should avoid this bait.

4. Many term sheets and leases provide that the fixed percentage increases will be calculated on a “cumulative” or “cumulative and compounded” basis. It is always eye opening to see how much quicker your base rent can increase when the increases themselves are compounded, particularly with larger rental rates. You should resist these increases too when possible.

At this point I realize that you may be green around the gills from all this escalation talk. I sincerely apologize. I did not mean to give you a haddock.