Commercial real estate contracts typically include detailed lease escalation clauses and rates that outline how and when increases to rent or operating costs will occur (and how both the property owner and the tenant are impacted as a result).
While the presence of lease escalations is very common in commercial agreements, there are many variables to how each escalation will work and what types of rate increases, or reductions will apply. It’s important to understand the different types of lease escalations and know exactly what each will ultimately mean for the profitability of your investment in the short- and long-term because some escalations take place annually, while others are every couple of years or at the beginning of a new lease term.
Commercial escalation rates can be easy to overlook, and could lead to some costly (and unexpected) expenses for you as an investor if you’re not fully versed on the implications of the escalation clauses in your contracts. This post will explain the distinctions between common lease escalation rates you should know about as a commercial investor, including:
- Fixed Escalations
- Variable CPI Escalations
- Stepped Increase Escalations
- Renewal Option Escalations
- Tax Pass-Through Escalations
- Direct Cost Pass-Through Escalations
Fixed escalations are quite common in commercial real estate deals, and they simply outline increases that will occur over time during the lifetime of a commercial tenant’s lease. Fixed escalations will vary, but typically they’re structured as a small, set percentage that will increase (such as 1-2 % each year) according to the agreement. The escalation amount could also be structured as a dollar amount per square foot as well (i.e. $1 increase per square foot a year).
Variable CPI Escalations
Variable Consumer Price Index (CPI) escalations are popular (particularly for commercial property owners) because they allow for variable adjustments over the course of a lease, that are in line with inflation trends. This protects your investment by allowing you to adjust rent or cost reimbursements when inflation spikes occur. These clauses are typically written with a limit in place though, to protect the renter’s interests and keep their rent as stable and manageable as possible.
Stepped Increase Escalations
In a stepped increase escalation, you can apply rent increases on your commercial property that take place over a certain amount of time, with increases being applied in pre-set amounts (or steps) each year. In a stepped increase escalation clause, you can use the square footage of your commercial building to determine the rate increases, and add to the price per square foot each year of the lease.
Renewal Option Escalations
Commercial leases are usually structured over a long period of time, but in the event that the lease term does draw to an end on your triple net commercial lease, there’s an opportunity for you to adjust the rent amount of your building. If your property is in a hot market, a contracted rental amount may have forced you to rent your building for below the going rate in your area. You can use this escalation to your advantage to structure a rental deal that’s fair and profitable for you as part of your new lease terms.
Tax Pass-Through Escalations
Pass-through escalations help account for property tax increases that may occur during the term of your tenant’s commercial lease. If property taxes increase substantially during your tenant’s lease term, you can pass along a percentage of that increase to share with the tenant so you don’t have to absorb it all yourself.
Direct Cost Pass-Through Escalation
Direct cost pass-through escalation clauses outline what will happen if an increase in direct costs (such as utilities, maintenance, security, etc) occurs during the term of your tenant’s commercial lease. The party responsible for these costs will vary based on how your commercial lease is structured, but it’s important that the clause is very specific as to who’s responsible for the operating costs and who’s impacted (and how) when prices go up.
Net lease real estate, along with all the different escalation clauses that can or may already be built into a long-term rental agreement on a commercial property you’re interested in, can be complex unless you understand all the different factors you should be looking for (and avoiding).
Sands Investment Group has expertise in all the complexities and variations of triple net property deals, and we know how to help you navigate escalations so that you don’t encounter anything unexpected or unfavorable in your investment.
Want to learn more about NNN properties for sale and speak with an industry expert about current commercial investment opportunities? Get in touch with an expert today by calling 844.4.SIG.NNN or sending us an email at info@SIGnnn.com.