Thank you to everyone who joined us for last week`s article on rent percentage. Today`s article discusses the method of calculating the additional rent, called IPC. Although rarely seen in new transactions, the CPI is still used to a lesser extent in commercial real estate leases, most often in government leases. The formula for calculating rent increases for an index lease is quite simple: when you rent any type of property, whether you are the landlord or the tenant, make sure your lease is clear about what the rent is and what inflation adjustments apply to the rent. Any lease document can be revised, even if some parties say they are using a standard lease. There is no such thing. A lease is an agreement between two parties, and you need to revise it to include a language that suits you. As always, consult an expert. In real estate, the term « base rent » is often used to describe the minimum amount of rent charged for a variable rental space. In the case of an index lease, this usually corresponds to the amount that is calculated for the rent at the beginning of the lease. However, with other types of leases, it is possible to pay a percentage of sales in addition to operating costs or in the case of retail.
Selecting a specific index. As mentioned above, there are a variety of indices and considerations that should be attributed to the right CPI given the space, asset, and duration of the lease. Care must also be taken to analyse the population group and categories of articles. Avoid seasonally adjusted indices. The Labor Department`s Bureau of Labor Statistics yesterday released the latest consumer price index figures using the All Urban Consumers Index, which rose 0.2 percent in August, but it was only for one month and it was not seasonally adjusted. The seasonally adjusted figure increased by 0.3%, the largest increase in 6 months, due to the increase in housing and medical care. Inflation is not what it used to be. In the 1980s, the CPI was approaching 20% and the largest living economist said it would rise to 25%.
It has risen to 2%. Our economy today is driven by a different wage-price spiral and low inflation helps borrowers and hurts homeowners and savers. Inserting a CPI adjustment can still make a difference in a long-term lease, as shown in the table below, which compares a CPI of 1% to a 2% adjustment of the CPI over a 25-year period. A gradual increase in the rate of 1% per year translates into an additional income of $378,000 over the 25-year period, and assuming a capitalization rate of 10%, the market value of the property increases by $338,000, or 33%. In this case, it might be helpful to think of a variable lease similar to a variable rate mortgage. For example, if you have a variable rate mortgage, its changes are usually related to the Cost of Funds Index (COFI) or the Treasury`s constant one-year maturity series. Meanwhile, changes in an index lease are usually linked to the Consumer Price Index (CPI), which measures inflation. As a landlord, your biggest advantage with this method is that rent increases, since they are based on an independently published index, are less likely to be refused by the tenant. This applies especially if you include a sample calculation in the lease agreement, which shows how increases are calculated on an ongoing basis. So why is the CPI important for commercial real estate? It turns out that the CPI is used by some commercial real estate leases to fairly increase (or decrease) the rent that must be paid by a tenant to cope with changes in national or regional inflation.
To better understand the rise in the CPI, consider this example: the Consumer Price Index (or CPI) is a set of indices generated by the Bureau of Labor Statistics (BLS) that « measure the prices paid by urban consumers for a representative basket of goods and services. » In the past, the CPI has been used in commercial real estate leases and « escalator clauses » or « index clauses » leases to equitably increase (or even reduce) the rent that must be paid by a tenant to cope with changes in national or regional inflation. A basic articulation of such an INDEX CLAUSE of the CPI would be a percentage change in rent before the year, where the change is calculated using a formula of (value of the current index – value of the basic index) above the value of the basic index. In recent years, many homeowners have moved to stable increases over defined periods of time. However, with the return of inflation, cpi increase clauses see a return to greater utilization. It`s important to keep in mind that the majority of recent leases have used fixed lease steps (i.e., 2%/year or $0.50/SF/year) as opposed to CPI adjustments, which reduces the time it takes to determine the rent adjustment. The creation of a CPI clause involves a number of decisions. There are several different CPI indices depending on factors such as location, type of consumer, goods and services included, and period of the core index. Each of them is important for understanding what is being measured, and choosing the right index can make a significant difference in the long run. For example, a retail lease may want to focus on goods and services or types of consumers in order to most closely align the increases with the sales of the tenant who is experiencing the rent increase. Similarly, it may be important to ensure that the index region is linked to the location of the property.
Some areas require special care and the creation of a CPI clause must be carefully tailored to the terms of the lease. The initial base rent of the lease is increased each June 1 by the increase in the CPI relative to the base index. The base index is the value published immediately before the start of the lease. These numbers are only valid for the month of August and leases must use the year number. The index for all items rose 1.1% in the 12 months to August. The index for all items minus food and energy rose 2.3% in the 12 months to August. The food index remained unchanged last year, while the energy index fell 9.2%. As you can already guess, a general increase is a simpler method. A flat rate is used to calculate the rent increase, so you always know what to expect. This is also the main advantage of this type of rent increase.
You have a fixed percentage for how much the rent will increase with each rental review, so it`s much easier to prepare in advance. You know exactly how much your income needs to increase to cover the rent increase. The clauses of the CPI have inherent trade-offs. On the bright side, they are historically consistent, flexible in their application to specific areas, reduce disputes, and have great practical influence in both trade discussions and economic analysis. However, they have been criticised for concentrating closely on certain goods, which are not in line with the reality of the economy, for not taking into account the relative demand in an area of high demand and for not taking into account the substitution by consumers of goods at lower prices. In addition, they tend to benefit tenants when inflation is low and landlords when inflation is high. Overall, however, they are still considered a credible form of lease indexing. Timing and frequency of adjustment. An important decision in a CPI clause is to determine how often the adjustment is made. Annual? A rental period? Pay close attention to when the indexes are published and specify when the adjustment will take effect.
In order to accurately calculate the LLCrease RENT, the CPI table must be referenced annually on the government website. Most leases refer to the index published immediately before a certain date. It is common for there to be a 2-month delay in the publication of CPI tables, so that, for example, a start date of 6/1/14 would mean the index published for 4/14. I added a sample CPI table with hypothetical future index values to complete the exercise. Typically, index leases consist of four components: a base rent, a usage index, a rate of increase, and a growth cap. We`ve taken a moment to clarify each of them below so you can get a better idea of how to structure your index leases in the future. To refine the selection of the index to be used, most lessors simply choose the CPI index, which was published immediately before the start of the lease. This means you can choose any clue you want for your lease. As a landlord, you have many types of leases to choose from. There are single-network leases, triple net leases, multi-level leases, and index leases, to name a few. With that in mind, below is your guide to index leases. Read on to find out what this lease is and how it is used in commercial real estate, as well as the unique pros and cons of choosing this method.
Armed with this knowledge, you should be able to decide if using an index lease is the right choice for you. Whether you`re renting offices, a warehouse, or a retail store, your lease likely contains language that links the rent you pay to the Consumer Price Index. Only the owner should benefit from the idea, as rental income retains its purchasing power. The problem is that there is more than one consumer price index and there are different ways to calculate each, so make sure your lease includes a very specific language. .