Rent is more than a Broadway hit. In fact, for many facility and property managers, it is the life blood of their organization. For a manager in the built environment, rent, simply defined, is payment by a tenant to the landlord to occupy leased premises. This article will explore fixed rent, rent escalation options, percentage rent, and the how base rent and additional rent are employed.
Fixed rent can mean both a monthly payment and rent without extras. When the tenant’s only monetary obligation is the payment of a fixed rent, the lease may be called a gross lease. When the tenant pays not only a fixed rent but also other expenses—including operating costs, taxes, and insurance—the lease may be called a net lease, of which there are many variations.
Rent escalation is a lease provision in which the landlord requires the tenant to pay a higher aggregate rent by adjusting the annual base rent by an agreed method during the term of the lease agreement. There are two reasons for this.
- to increase the building’s revenue and, therefore, its value
- to ensure that the base rent will keep up with inflation
The most common way to escalate rent is through a procedure called stepped rent. Stepped rent is used when a tenant wants to lease the space but objects to the present asking rate. Stepped rent can be used in good markets as well as bad. Assume that the asking rate is $20 per rentable square foot. By making the following adjustment, both the tenant and the landlord might be satisfied:
- Year one $18
- Year two $19
- Year three $20
- Year four $21
- Year five $22
The average rental rate over the five years is $20 per square foot. Although the landlord has a lower cash flow during years one and two, this loss is offset by higher rent values in years four and five, increasing the building’s value. In a strong market, of course, the owner can start out at $20 and increase each year by a fixed amount.
Stepped rent has many variations, depending on the need to make the deal and the creditworthiness of the tenant. If you are considering a stepped rent agreement, make sure the tenant has the capacity and integrity to pay the higher rent in the latter part of the lease.
The CPI (Consumer Price Index) can also be used to determine the rate of rent escalation. Every month the Bureau of Labor Statistics of the U.S. Department of Commerce publishes the CPI, which indicates changes in the cost of living. The CPI acts as a price indexing scale for the landlord to use in measuring the loss or gain of the dollar. By using this index to determine rent, the landlord can feel assured that the net rent is not eroding during the term of the lease. A CPI clause in a lease should contain some of the following elements:
- identity of the particular index that is to be used since different indexes measure different items
- geographic coverage, such as the U.S. City Average or a local area index
- index base and base year
- percentage of the CPI increase that applies to and increases the base rent
- provision for a substitute replacement index if the particular CPI index is discontinued
In a soft market, and because of tenant experience with the economic situation during the early 1980s when the CPI rose dramatically because of rampant inflation, tenants may be reluctant to agree to this adjustment formula to the base rent. The downside for the owner is that the building’s expenses, or the overall CPI, may increase at a faster rate than the rate of the agreed upon escalation. It is a bonus for the owner, however, if the rent increases faster than expenses or the overall CPI.
A flat fixed-annual-percentage increase in base rent is a way of escalating rent by increasing it by a fixed percentage each year. The disadvantage of a fixed-percentage increase is if the CPI goes higher than the fixed rate, the fixed rate will not be keeping up with inflation.
Some leases for retail operations specify that rent is paid based on a percentage of the gross sales of the business against a base rent. While most office building leases are not based on percentage rents, you may have retail concession space you want to lease based on a percentage of the sales. This approach lets the owner participate in the success of the tenant. Some states restrict percentage rents, so if you decide to use this method, make sure it is legal in your state.
Profitable rents based on a percentage of sales require a tenant, such as a restaurant or store, which has experience operating a retail establishment. Good operators are also knowledgeable about what it takes to set up a retail establishment. They also may be sharp negotiators when it comes to owner contributions for tenant improvements and rent abatements.
A lease based on a percentage rent can be troublesome, because it is often difficult to learn the tenant’s true gross sales. One way to solve this problem is to require the tenant to report his or her sales and then give your auditor permission to examine books and records. Make sure the lease lists all of the records the owner can examine. Your auditor should have access to:
- general ledgers
- all records that verify sales
- bank statements that verify income
- purchase invoices
- cash register tapes
- inventory records
- tax returns
- state and local sales tax reports
Most audit clauses specify that if the owner discovers an audit discrepancy exceeding what has been reported, that amount, plus interest is due the owner. If this discrepancy exceeds five (5) percent, the cost of the audit will also be added to what the tenant owes the owner. If the amount exceeds ten (10) percent, the owner may have the option to cancel the lease.
Base Rent and Additional Rent
Base rent is the monthly recurring rental charges stated in the lease. Base rent may include an escalation formula. The purpose of this rent is to pay the owner’s debt service, cover the depreciation expense, and provide a rate of return on the investment.
Additional rent is any and all charges besides base rent the tenant must pay according to the terms of the lease. Usually this means paying a portion of the expenses the owner incurs for operating the building. The exact mechanism for how this is done depends on how it is defined in the lease. There are many ways to calculate additional rent, so make sure the lease clearly outlines all charges. The following is a list of items typically covered under additional rent.
- building operating expenses
- annual expense adjustments
- CAM (common area maintenance) charges, such as those usually associated with retail malls
- late-payment fees for overdue rent
- legal fees and court costs to get the tenant to comply with the terms of the lease, or to enforce the owner’s remedies
- collection costs for hiring a collection agency to obtain money owed from a current or former tenant
- expenses related to building repair
- miscellaneous fees, such as the bank charge in the event a tenant’s check bounces
*Note-Some of these items may also be classified as expenses.
The largest category of additional rent is usually operating expenses. A building’s operating expenses are all of the costs incurred to manage and maintain the property. The tenant pays a portion of these expenses. Depending on the lease, tenants will pay one-twelfth of the annual operating expenses along with the base rent. Once a year—by a specific date stated in the lease—the owner prepares a statement of operating expenses to be paid by each tenant. This annual statement will reflect any increase or decrease in expenses. There is no industry-wide standard definition of what constitutes operating expenses or CAM charges. Each lease must specify all eligible expenses, which could be 100-plus items in certain cases. If the definition of expenses in the lease is not complete, clear, and detailed, a tenant could successfully dispute some of the charges. Operating expenses can add significant costs to the owner, so it is in the owner’s interest to pass along as many expenses as possible. On the other hand, it is in the tenant’s interest to limit the items that can be charged as an operating expense. Agreement on exactly what items will be charged to the tenant, along with how they are calculated, should be negotiated before the lease is signed. CAM charges are expenses incurred to maintain the sidewalks, parking lots, landscaping, and other common areas and common building systems. CAM charges are calculated for specific areas of the property (usually in retail malls). Typical common areas include:
- facilities provided for the common use or benefit of the tenants and/or public( e.g. corridors, lobbies, mechanical rooms, mail rooms, and restrooms)
- vertical penetrations not for the exclusive use of any one tenant (e.g. elevators, stairwells, pipe shafts, and vents)
Items that cannot be charged to the tenant may include:
- capital improvements (except those that may reduce operating costs and thereby benefit all the tenants)
- debt service, depreciation, ground leases, and associated fees
- cost of altering other tenant spaces
- brokers’ commissions
- marketing and legal costs associated with obtaining tenants
- excessive payments for goods and services affiliated with the owner
- services performed expressly for one tenant
- executive salaries and benefits above the property manager level
- costs of items that have already been reimbursed to the owner
- insurance or other sources
- late-payment charges or interest incurred when the owner fails to pay vendors or taxes in a timely manner
The term additional rent may vary from area to area, and even from lease to lease. As lease law develops and changes, the courts, regulatory agencies will proffer new interpretations on the requirements and responsibilities of all parties involved in a lease. Facility and property managers will need to follow these developments closely.
This article is adapted from BOMI International’s Leasing Reference Guide. More information regarding this is available by calling 1-800-235-2664, or by visiting www.bomi.org.