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 [email protected] or (949) 706-6621.