Consider Basing Rent Escalations on Fixed Percentage, Not CPI Increases

November 1, 2003

Keeping up with inflation is important to your bottom line. So you must be careful when deciding how much to increase the minimum rent each year for the tenants in your center. Although you may have relied on the Consumer Price Index (CPI) as a minimum rent escalator, it may not always be your best choice. That's because the CPI is subject to reporting errors by the U.S. government. And there's no way to predict from one month to the next how much the CPI will increase. (The same arguments have been used to justify the use of a “fixed” CAM increase.)

Keeping up with inflation is important to your bottom line. So you must be careful when deciding how much to increase the minimum rent each year for the tenants in your center. Although you may have relied on the Consumer Price Index (CPI) as a minimum rent escalator, it may not always be your best choice. That's because the CPI is subject to reporting errors by the U.S. government. And there's no way to predict from one month to the next how much the CPI will increase. (The same arguments have been used to justify the use of a “fixed” CAM increase.)

For these reasons, you may want to consider basing your annual minimum rent escalator on a fixed percentage rather than on the CPI, suggest Ronald Gern and Howard Sigal of General Growth Properties. We'll explain the benefits and point out the risk involved in using a fixed percentage escalator. And we'll give you two tips to follow if you decide that a fixed percentage escalator is right for you. Plus, there's Model Lease Language that you can use to put the fixed percentage escalator in your lease.

Benefits of Fixed Percentage Escalator

A fixed percentage escalator for minimum rent offers you three main benefits:

Eliminates guesswork. With a fixed percentage escalator, there's no guesswork involved about how much the tenant will have to pay in rent. Both you and the tenant will know right from the start of the lease what the minimum rent will be for each year of the entire lease term, says Sigal. So you'll know exactly how much rent you'll be taking in over the entire lease term, which will help you with long-term planning for your center. And the tenant benefits, too. It will know exactly how much money it will need to budget towards rent over the entire lease term, he adds.

Speeds up lease negotiations. By using a fixed percentage escalator, you won't need to spend time negotiating a cap on the amount of the rent increase, says Gern, which is something a tenant may ask for and an owner may then have to do if it uses the CPI as a rent escalator. That's because the rent will increase by a set percentage each year. Since the percentage won't change, there won't be anything to negotiate. As a result, rent negotiations are streamlined, he says.

Saves time. By using a fixed percentage escalator, your staff will no longer need to spend time hunting down the correct CPI chart and plugging figures into some convoluted formula, says Sigal.

One Big Risk

But a fixed percentage escalator also carries one big risk for owners. That is, you could get burned if inflation spikes over the lease term, warns Gern. If the fixed percentage escalator isn't set high enough to cover inflation, your wallet may take a hit, he explains.

Two Tips for Using Fixed Percentage Escalator

Once you've weighed the benefits and risk involved and decided that a fixed percentage escalator is right for you, follow these two tips:

Use fixed percentage in short-term leases only. It's best to use a fixed percentage escalator with short-term leases only—say, for leases of five years or less, says Sigal. This protects you if inflation spikes and stays high for a long period of time. For long-term leases, you may want to use a CPI escalator or some other cost-of-living escalator, over and above a fixed rate floor, he says.

Do your homework. When using a fixed percentage escalator, you need to pick a percentage that's high enough to raise the minimum rent amount each year to keep up with inflation and other cost uncertainties, says Sigal. To help you pick a percentage, Sigal suggests checking certain factors like these:

  • Historical data on inflationary increases from, say, the past decade—the longer the period you look at, the better the picture you'll have;

  • Current economic conditions;

  • Your center's budgets; and

  • Your center's current capital expenditures and budgeted capital expenditure for the future.

The more information you review, the more likely you are to pick an appropriate fixed percentage for your center, says Gern. Once you've decided on a percentage, you have to get the tenant to agree to it. Expect some negotiation. Being consistent from one tenant to another on the percentage you pick will help you get tenants to agree to the escalator, says Sigal.

How Fixed Percentage Escalator Works

How does the fixed percentage escalator work? You simply multiply the prior year's annual minimum rent by a percentage that's equal to 100 percent plus the fixed percentage escalator, says Gern. For example, say you choose a fixed percentage escalator of 5 percent. To figure out the new, increased minimum rent, you would multiply the minimum rent for the previous lease year by 105 percent (100 percent + 5 percent), he explains.

Add Lease Language

Here's some Model Lease Language that you can use to set up a fixed percentage escalator. Add this language to the minimum rent clause in your new lease or lease renewal.

Model Lease Language

Tenant's annual payment of Minimum Rent shall increase during the second and each subsequent lease year to an amount equal to the product obtained by multiplying Tenant's annual Minimum Rent for the previous lease year by [insert escalator, e.g., 105%].

CLLI Sources

Ronald L. Gern, Esq.: Senior Vice President & General Counsel, General Growth Properties, Inc., 100 N. Wacker Dr., Chicago, IL 60606; (312) 960-5000; rgern@general growth.com.

Howard Sigal, Esq.: Vice President and Asst. General Counsel, General Growth Properties, Inc., 100 N. Wacker Dr., Chicago, IL 60606; (312) 960-5000; hsigel@generalgrowth.com.

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