Rent and Escalation Clauses

At some point in the life cycle of most businesses, a business will have to enter into a lease agreement.  Typically, the first issue that is negotiated between the landlord and the potential tenant is the amount of rent for the leased premises.  Often, the landlord will quote the potential tenant a rental amount that is a fixed dollar figure per square foot of rentable space.  This figure is typically referred to as the minimum or base rent and it may not be the only rent the tenant is obligated to pay under the lease agreement.

Unless the landlord and tenant enter into a pure gross lease, most tenants that are leasing commercial space will be responsible for certain other costs that are either added to he base rent or are billed separately to the tenant.  These expenses can include real estate taxes, insurance, common area maintenance and certain operating expenses of the landlord.  In addition, and in some retail leasing arrangements, a tenant may be required to pay percentage rent, which is often computed as a percentage of the tenant’s gross sales and is in addition to the base rent.  When it comes to rent, what is customary and standard practice will depend on the type of the space rented, whether that be office space, shopping center space or industrial space.  It is important for landlords and tenants to understand the nature of the transaction and what is customary and standard with respect to rent in the market.

It is fairly common for a commercial lease agreement to contain an escalation clause.  The rent escalation provision can be structured in any number of ways, but is typically either a fixed amount, based upon some objective index (such as the CPI) or is the actual increase in the landlord’s operating and maintenance expenses.  Due to the relative bargaining positions and the nature of the leased premises, a landlord might prefer the escalation provision to follow the actual increase in the expenses that are being passed along to the tenant each year.  In drafting an escalation provision in this manner, the landlord’s objective is to avoid the absorption of any of the increase in the operating and maintenance expenses.  If the escalation clause provides either a fixed amount or a set percentage based upon an index, there is risk that the landlord may have to absorb certain operating and maintenance expenses to the extent those expenses exceed the fixed amount or the percentage increase.

On the other hand, a tenant might prefer an escalation provision to be a fixed amount or be a percentage that is based upon an objective index.  Under these two scenarios, the tenant can more precisely predict what the increase in rental expenses should be in subsequent years.  However, if the landlord will not agree to either of these methods and requires the escalation clause to be based upon actual increases in operating and maintenance expenses, the tenant should try to get the operating and maintenance expenses clearly set forth in the lease agreement and limit the expenses based on a reasonableness standard.

In some leasing transactions, it is common for the escalation provision to be drafted in such a way that it incorporates a couple of the methods discussed above.  In longer term leases, there might be a base rent escalation clause to take into consideration certain changes in the leasing market and there might also be an escalation provision that requires the tenant to pay the increase of the operating and maintenance expenses.

It is important that the parties clearly define all of the concepts and key terms that make up the rent and escalation provisions of the lease.  The terms that typically need to be defined in these provisions are: base rent, insurance, taxes, common area maintenance and landlord operating expenses.  If the parties decide to provide an escalation mechanism that is based upon an objective index, such as the CPI, it is advisable to provide an example of how the rent escalation is going to be calculated each term.

In a commercial leasing transaction, it is in the interest of both the landlord and tenant for there to be an element of predictability in the calculation and determination of the rent, when it is to be paid and under what circumstances it can fluctuate.