Avoiding an immediate rent increase
Base year. Office tenants are generally responsible for increased building expenses and real estate taxes over some base point – either a base year or an expense stop. These escalations can easily outstrip the base rent, and courts will generally enforce the provisions in a lease you sign regardless of how much your rent may increase. So it’s important to understand the mechanics of escalation formulas.
The base year is generally the first 12 months you occupy your space. The expense "stop" is a number representing average, reasonable operating expenses per square foot during those first 12 months. Because it is the lease’s reference point, if you agree to an early base year or an expense stop that’s too low, your landlord will get higher profits every year of your lease. Landlords sometimes argue that the base year should be the 12 months preceding occupancy, but that would mean you’d face a rent increase the day you move in.
If your building has been functioning for a while, the previous 12 months’ operating expenses are a good basis for estimating the expense stop. Check the estimate with management companies that handle similar buildings to see whether your stop is within the normal range. The experience of comparable buildings is also a good source if your building is new or if for some reason you don’t have access to its expense history.
Fair share. Rent escalation formulas, whether tied to direct operating expenses or to indexes (see next section), should limit the tenant’s obligation to pay a fair share of a building’s total costs. Usually this means you’ll be responsible for expenses in proportion to how much of the building you lease.
Watch out. Some leases make the building’s "rented" area rather than "rentable" area the denominator in the fraction. This means you, not the landlord, would pay operating expenses for the building’s vacant areas. If your landlord adds floors or converts storage or basement space to office space (thereby adding to the rentable area), the fraction used to determine your share of the building’s expenses should reflect this.
And be alert for clauses that don’t clearly spell out how the landlord will calculate your share of the building’s area. In one case involving a ground-floor tenant whose lease did not contain a formula, a Pennsylvania court decided that the tenant should pay escalations in the same proportion as its rent to the total rent roll. A bad deal for the tenant. Ground-floor space is often more than double the cost per square foot of office space on upper floors.
Indexing the rent. As an alternative to a complex operating expense clause, some landlords index their rents. This lets landlords keep their books private. It also saves tenants from a costly, time-consuming review of expenses that may produce legitimate disagreement.
But be wary. There are a variety of indexes, with many subtle variations in common use, and their behavior can vary substantially. It’s surprisingly common for even large, sophisticated companies to be hit by higher rent escalations than they anticipated. In 1969, for instance, Avon Products signed a 27-year-lease for nearly half of a 50-story tower in Manhattan. Avon’s rent increases were tied to the "porter’s wage" – hourly wage and fringe hikes that certain employees receive under a union contract. Because the contract calculated fringe benefits on a weekly or yearly basis, Avon’s landlord, Sheldon Solow, had to translate these fringe benefits into an hourly rate.
For ten years, Solow assumed for the purpose of his calculations that the union employees worked a 40-hour week. But in 1980, Solow notified Avon he was revising his calculations to base them on the actual hours employees worked – 31 hours a week. The effect on Avon was dramatic: its rent would jump $780,000 a year, more than $13.5 million over the remaining life of the lease. In 1981, Avon sued Solow over the increase but the case was tossed out. The judge ruled that the lease required the parties to settle by arbitration. Since then, they have been fighting procedural skirmishes. Seven years after the litigation began, Avon has paid substantial legal fees but still doesn’t know its actual rent.
To avoid this predicament, always include a sample calculation in your lease and make sure you understand the implications of any index proposed as the basis for figuring your escalations.
The most common escalation formulas link rent increases to the Consumer Price Index. The CPI measures the cost of food, clothing, recreation, residential rents, and other goods and services, but has no component relating to commercial rents. The components of an index like this may increase far more than the general inflation rate or the cost of running a building.
The CPI-W, a national index, covers only urban wage earners and clerical workers. The CPI-U covers all urban consumers. The CPI-U is generally favored as an index for rent escalation because it covers about twice as many people and is less volatile.
If your city is one of the 28 covered by a metropolitan CPI, your landlord may propose linking your rent to that rather than to the more general CPI-U. But the metropolitan CPIs are much more volatile and, depending on the local economy, may fluctuate in ways entirely unrelated to the cost of running a building.
Another common gauge, the Producer Price Index, is also highly volatile. It measures changes in large quantities of certain commodities at the wholesale level. During the 1970s, when metals and petroleum products made the index rise dramatically, landlords benefited from the index. One group of Florida tenants sued heir landlord, claiming that the use of this index was unconscionable. The court turned them away.
Overlapping escalation formulas. If your landlord indexes base rent in addition to passing through certain operating expenses like fuel, electricity, and real estate taxes, you should negotiate for a partial CPI or porter’s wage formula. Otherwise, you’ll pay twice for those increases.