How Did My Once Great Rental Rate Get So Out of Whack?

It is customary in commercial real estate to have rental rates increase over the term of the lease. These increases typically take the form of fixed rent steps (i.e., $.50/sf annual increases) or percentage increases (i.e., 3% annual increases).  While these increases may seem nominal, over a 10 or 15 year term they can add up. This is especially true with respect to annual percentage increases due to the compounding effect.  Assuming a lease called for 3% annual increases, by year 10 of the term, rent would be 130% of the first year’s rent and by year 15 it would be 151% of the first year’s rent.

There are two justifications typically put forth by landlords for annual rate increases.  Primarily, they are justified as hedges against inflation; that is, they are intended to preserve the net effective rents on an inflation adjusted basis over time. The second major justification is to create asset appreciation over time.  As commercial properties are valued based on cap rates applied to net operating income, by growing rent over time, the asset will theoretically appreciate.  Keep in mind that for publicly traded REITs, there is no GAAP income growth over the lease term.  Under established accounting principles, these companies must report the average rental rate each year over the term (similarly, a tenant following GAAP accounting shows the average rent expense each year).

The problem is that these two rationales don’t always match reality.  Let’s take them one at a time.  Rental increases are needed to adjust for inflation.  This makes sense assuming that the true value of the product (in this case, as measured by market demand) is increasing over time. Thus, while there has certainly been inflation over the past 20 years, certain products like computers and phones have actually gone down in price due to advances in technology and increased competition.  Manufacturers and retailers can’t command 3% annual increases in price for their product irrespective of market conditions. The fact is that rental rates in the Philadelphia metropolitan area have not kept up with inflation over time because demand for space has not outstripped supply enough to drive up rents.  Thus, leases with annual rent increases often reflect economics which are higher than the current “market” for that building at some point in the lease term. Furthermore, if these increases are truly intended as protection against inflation, they shouldn’t overreach.

Tenants should be aware that they may be paying a double escalation if they have a gross lease structure (i.e., one where the rent includes the first year’s operating expenses and taxes but the tenant pays annual increases in those expenses). By way of example, assume a tenant is paying $30/sf for rent (which includes $4/sf for base year taxes and $8/sf for base year operating expenses) with 3% annual rent increases.  If operating expenses and taxes go up 4% in year one, then in year two the tenant will pay $30.90 in base rent (i.e., $30x[1.03]) PLUS another $.48/sf for operating expense and tax escalations (.04x [$4+$8]).  In effect, the tenant is paying a double inflation adjustment on the $12 of base year operating expenses and taxes embedded in the gross rent.

Now let’s take the second justification.  Landlords need to create building appreciation.  If leases have rental rates that are higher than the current market rent commanded by the building, any lender or purchaser for that building will “mark the rents to market” when it does its underwriting; that is, it will value the building based on current market rents (if lower) as opposed to the contract rents under the leases. Thus, rising rental rates in leases don’t create future appreciation for the building if the market hasn’t kept pace with the contracted rate.

In response to the foregoing arguments, some landlords have said “I need a certain overall return on the lease so if you don’t want escalations, I’ll simply restructure my proposal with a flat rent that accomplishes the same net return over the term.”  For tenants who need to straightline their rent expense for accounting purposes, this is effectively what they do anyway.  However, by increasing the rent in the early years to achieve a level rent structure, from a cash flow standpoint (or for from the perspective of tenants who don’t straightline rent expense) this landlord may now be at a competitive disadvantage in the early years of the lease.

What does all of this mean for tenants?  Most tenants coming off of long term leases in the Philadelphia metropolitan area will find opportunities to reduce their rental costs when it comes time to renew and, in some cases, may even be able to upgrade to a better building without increasing their rent expense.  Though the analysis will ultimately depend on the strength of the particular building at that time and the tenant’s unique alternatives, tenants should carefully evaluate how their rent expense compares to current market opportunities and conditions.  Tenants should take a long, hard look at proposed rent escalations before agreeing to them.  At a minimum, they should make sure they are not paying double.

For more information contact Glenn Blumenfeld

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