What Is A Fair Annual Increase In the Rental Rate For A Commercial Lease?
By Steven Silverman, CCIM Tampa Commercial Real Estate
It is often a bone of contention between Landlord and Tenant what the annual rate of increase in the lease rate should be on a commercial lease.
I have a situation right now where a Letter Of Intent has been presented by a tenant. The landlord wants an annual percentage increase in the lease rate of 3%. The Tenant is demanding a flat lease rate for the entire first term. Then at the end of the first term they would accept a lease rate increase for the second term, which similarly would be fixed for the duration of second lease term. The Tenant believes that not only should there be no increases in during the lease term, they also feel that the landlords request for an annual 3% increase is highway robbery because in the last few years rate of inflation has been much lower than 3%.
The tenant’s sentiments were expressed in an email “our finance people don’t agree to spread out the increases annually of over the term of the lease because with the annual increase requested by the Landlord, the lease rate of would be astronomical at the end of our first term and the 2nd n 3rd term of the lease would be unaffordable. This is not smart business.”
One solution be to have an annual increase, but peg the increase in the consumer price index. This way, if the CPI increased by only one half of one percent, then the lease rate would increase by only one half of one percent.
The landlord and the tenant are both frustrated with each other. Landlord requested me to research what a fair rate of increase in the lease rate would be. I went back and doing research on the historic inflation rate in the United States which is reported by the Bureau of Labor Statistics.
• From 1914 to 2012, the inflation rate in United States averaged 3.4%.
• However, between the year 2002 011 the inflation rate was only 2.55%. This is an average. In 2009 for instance the rate of inflation was actually -0.3%. The Tenant may well argue that in this year their lease rate of should decrease.
• Between the years 1968 and 1982 the average inflation rate was 7.38%. However, this is also an average. In some years, the inflation rate was much higher. In 1980 the inflation rate was 13.6%
In reviewing the historic statistical information is clear that the landlord’s proposal of an annual 3% increase in the lease rate is fair. It is lower than the historical long-term rate of inflation. If there as an annual adjustment factor of the lease rate the claimant would be very happy in 2009 when their rent would have decreased. However they would not be so happy if it were 1980 and their lease rate increased by 13.6% in one year.
The Tenants proposal of a flat rate of entire lease term of the is unfair. It would be interesting to see if that tenant would agree not to raise prices on the products and services that they sell to their clients during the first lease term. To do this , they probably also have to get their staff to agree to flat wages during that same period and get their suppliers to hold prices to todays level.
Using the consumer price in the annual adjuster of the lease rate a is a double-edged sword. Inflation is a real and it is not going away. If a business needs to take care of inflation in a predictable manner, it seems that the 3% rate of increase is a fair compromise. In fact, it is more to the benefit of the Tenant. It is hard to believe that the current low rates of inflation will continue given the amount of borrowing undertaken by the USA. It would not be surprising to see inflation rates return some years down the road. The tenant has the opportunity to limit their risk of lease rate increase to 3%.
36 Comments
Your information is very much valuable to me; however, I would appreciate to give me an example on how to calculate such increase using ur formula in the the following scenario:
My commercial property is located in Long Beach, CA and it will be used as a seafood restaurant. Lease payments will be $3000 monthly for 4 years . How much can I increase under your method?
Thanks a lot for your cooperation,
So if you are doing 3% annual increases which is generally accepted in our market
First year = $36,000 per year = $3,000 per month
Second Year + $37,080 per year = $3,090 per month etc
Once again, thanks a lot!
If the lease is triple net and the tenant is already paying for all of the operating expenses, why should there be an annual increase in rent? Any increases in operating expenses due to inflation are already paid by the tenant.
I argue this point with landlords all of the time but have yet to get rid of the escalators. I achieve reductions in the rate for my clients but have failed to eliminate the escalator entirely. I believe an all out blitz on base rent escalators by all NNN tenants is needed to change this unfair practice. There is no justification for increasing the base rent when the tenant pays actual CAM expenses. The base rent increases directly increase landlord profits, nothing else. Profits should not increase for doing nothing. Escalators are a rip-off.
So are you saying it does not cost the landlord more to live each year? He needs to at least increase his base rent by 3% to keep up with inflation, otherwise he is losing purchasing power each year. Simple economics.
Landlords have other non-fixed expenses besides CAM. Painting, roofing, siding, etc. When have those ever gone DOWN?
Even if it is a NNN lease, the landlords profits are eroded by inflation. So an annual increase makes perfect sense and is fair.
Does you mortgage rate on your home increase every year because of erosion? No.. Do stocks all have built in dividend increases? No… do your bonds or bank CDs have annual increases built in? No… The only reason increases are “fair” is when the value of the property increases due to supply and demand.
Value of money is dependent of the time. 3000 dollars today is not the same in one year. Money loses its value or purchasing power by the rate of inflation That is why 3 to 5% rent increase is norm.
The landlord invested his money in the property and expect to get at least same return each year not mention increase the return. If there no 3% increase which equal to inflation rate then no rent increase means landlord loss 3% each year. It is nothing to do operating expenses.
Inflation continually diminishes value of rental income to the landlord. A restaurant owner would never freeze his prices even if his suppliers kept prices constant. Not raising rent when there is a tripple net lease will erode the return on investment of the landlord. Also it will damage the future saleability of the property.
Your comments are very helpful.
I would appreciate your comments on a commercial property I own outside of Pittsburgh, PA.
The former tenants had a five-year lease with no increase in rent. With one year left on the lease, a new tenant purchased the corporation and is paying the same rent until the end of the lease. He is a conscientious tenant and is working hard to make a go of the business. I need to increase the rent but I am not sure how much. Once that is established, I plan to raise the rent by 3% a year.
Can you advise?
As a landlord, the properties are in very high demand. We were missing out on the market demand. Once we realized that we were under a high demand, we shorten the lease terms and no longer give options to tenants to renew their lease, but rather renegotiate new leases, of course giving our good tenants the right of first-refusal. So, as fair if the demand is not there I agree a 3% increase is fair. As far as the CAM fees, we try to renegotiate contracts to keep cost down for our tenants. But, also I believe that landlords and lessees should carefully analyze their situation to establish the fair market rate. A lessee should certainly take a look of its operating advantages and disadvantages. We are relatively new in the industry, is there something else we should be aware of? Thank you.
Hi,
I have made an offer on a leasing a Motel for 25 years with new option to renew. In the lease offer landlord is asking for a 2% rent increase after first 5 years, so there would be 2 % rent increase every year from sixth year. My question is, since landlord will not be spending any money on upkeeping or maintenance of the property should he be getting this extra profit every year after fifth yf.
To me this is a good deal for you. The inflation target for the FED Reserve is 2% per year but we all remember when inflation was in double digits. In this deal you will not pay any increase for 5 years. After that the rent escalation is 2%. If inflation is running at 4% you will be able to raise your rates but the landlord is limited to his 2% increase
Hello,
We rent office space in a commercial building in Denver, Colorado since 2012. In 2013 their was change of ownership and since then we have had rent increases each time we renew the lease (typically 3 years). The increases were generally 6-8%. We also pay for CAM.
The landlord now wants to jack up are leases by 38% (no kidding). We have just a 1 week to decide as they didn’t warn us that this kind of increase was coming. Can we take some kind of action against the landlord?
Thank you
The devil is in the details of the lease agreement. When I do a letter of intent for clients I try to cover my tenant with lease options when the lease expires and also specify the escalations for each year if a lease option is exercised. A fair increase is 3% per year. However, if lease escalations are not addressed in the lease you dont have many choices. Many Buyers make their investment decisions based on the upside potential of a property. They make the purchase with the intention to raise the lease rates and increase their return on investment. You may have one of these Buyers as a Landlord
I understand that a 3% increase standard, and in Seattle (it’s booming here at the moment) the landlord wants to raise rent 6% each year for a 5 year lease. I just want a fair deal for both of us. Is 6% fair, and if not, what’s the best way to negotiate for this?
6% may be reasonable for a year or two if the landlord is giving you a special deal to help you move in and get your business started. However, over a protracted lease term, this is not sustainable. Then it is not good for you and it is also not good for the landlord. It is reasonable that a landlord should be compensated for rising costs that come with inflation. If he won’t accept a reasonable annual escalation then why don’t you talk to him about an annual escalation that is equivalent to the increase in the Consumer Price Index. That protects the landlord from inflation and in the current environment, it reduces your annual increase. It could come back to bit you. There have been times in our history that inflation rate much higher than 6%, but for the foreseeable future the annual CPI increase should not be extraordinary
good day,
may I know the average apartment rent increase per year in the phils for example rent is Php.5,000
I am working with a client to lease office space. Below is a proposal.
Option A: 3,850 RSF (Rent + E (Electricity)
Months 1 – 2 $0.00 per SF + E
Next 12 Months $18.50 per SF + E (5,935.00)
Next 12 Months $19.00 per SF + E (6,095.00)
Next 12 Months $19.50 per SF + E (6,256.00)
Next 12 Months $20.00 per SF + E (6,417.00)
Next 12 Months $20.50 per SF + E (6,577.00)
Base Rate will be for 2019 as the lease will start April 1, 2019
They have pass through expenses starting year 2020 and I want to CAP those to fair market.
Is 5% reasonable? should it be less?
Its a Class B building, half empty, ok part of town Dallas TX
Thanks…
Michael Cody overlooks an important reason people buy real estate, which is to obtain a reasonable return on their investment. He overlooks the fact that in order for the return on investment to stay steady, it should be increased for inflation over the term of the lease. Otherwise, the return decreases, in terms of actual purchasing power. For example, a 3% inflation rate actually decreases the purchasing power of a fixed rent payment by almost ten percent over a three-year lease term.
The leases I have dealt with provide for periodic COLA adjustments, along with adjustments for changes in the value of the property periodically (every 10-20 yrs) over the term of the lease.
Thank you for this article. I have taken over management of my mother’s commercial property in Utah, and this was a great help in deciding what to put in our 5th lease extension with our tenant for a sporting goods store. I’ve opted to raise it only 2% annually, in interest of keeping a happy, longterm tenant, especially since we are out of state.
I disagree with the comment above regarding it not being fair to increase rent if the lease is triple net. Many landlords, such as my mother, are on a fixed income consisting solely of what they earn from one piece of income property. My mother lives in a senior living facility, and the costs of rent, food, and care there are likely to increase at a much steeper rate than what I can raise the rent on the commercial property she owns. Futhermore, there are costs incurred by landlord which my mother does not pass onto her tenant. In the last 5 years she’s had to replace the 2 air conditioning units and remove and replace the entire roof. Furthermore, increasing in small increments reduces the risk of “sticker shock” in raising it all at once later.
We saw this happen to a longtime and much beloved business in our neighborhood, who’s senior citizen landlord had not raised the rent in over a decade. Everyone was up-in-arms when his son came in and attempted a very modest, well below market value increase. Tenant refused ANY increase, was evicted, and there was literally a bidding war between prospective tenants wanting to get into this highly desirable location in our hipster neighborhood. Don’t know what rent is being paid for it now, but I’m sure it’s several times what it was before.
I have a small business. I am renting an outside spot for 7 years my rent is about 4,000 now i got a letter from my landlord increasing my rent to 6,000. Take in mind my shop is about 10×20 tent. What is the new mexican law of how much he can increase. Is his increase far or is he over doing it.
The key issue is whether you have a signed agreement that states what you will pay. That is the value of a lease. It protects the tenant from such large increases.
Rent escalation is on an annual basis
First year will be $36,000 per year or $3,000 per month
Second year lease rate increase by 3%
Second year: Annual lease rate is $37,080 = $3,090 per month
Third year lease rate increase by 3%
Third year: Annual lease rate is $38,192.40 = $3,182.70 per month
etc
I have taken over managing my father’s affairs including a rental property. The tenant has just finished a 3-year lease at $2,000 a month with no increases. They want to renew for an additional 3 years. They pay utilities, but I pay for maintenance – repairs, painting, etc. What is a fair increase if I want to keep it flat for the next 3 years?
Think this article and discussion misses the main point on rental escalations, whatever the fed CPI says is fairly irrelevant to the rental segment and geographic markets you are in. Eg a 3% escalation for retail in Flint Michegan over the last 10 years would be very different from a 3% retail escalation in Seattle. However retail sector in general is being decimated by Amazon/ebay/wayfair etc. The point of the escalator is to charge a fair rent keeping up with the escalation (or de-escalation) of similar properties in the same market….
Maybe I should have scrolled down further before this post.. especially as Seattle already mentioned!
I live in Florida and rent a small spot in a gas station. The owner is raising the rent 100% from 1500 a month to 3,000 a month plus taxes and repair expenses to the ac and electric. Does anyone know if they could do thiis? We have been here for 5.5 years and we had increases year over year. Except last year. No new lease is set up so I have no choice but to forfeit my established business?
I am looking to lease a space (Florida) but requires a build. The build is estimated at 90k which the landlord is willing to cover $40k, I would cover the difference. They want me to sign a 5 yr lease with 4% yearly increase. Is this reasonable?
It is reasonable for a landlord to try and recover some of his expenses and amortize them over the lease period. However, you may also be improving his property by building out his space. I would try to get down to a 3% escalation. If he won’t budge on that try to negotiate a month or two additional free rent
I leased a fairly undesirable piece of land in Oklahoma City, upon renewal of the 3 year term, landlord tried to double the lease from 3000@month to 6k. I closed that location and moved to an awesome spot for 3500@month . I purchased this piece of land, with frontage that has more traffic then almost any spot in the city. All I’m saying is look around you may find a better spot. This land was owned by an older man, I walked in and asked him id he was ready to retire. He was. It can happen.
Good job. Maybe your rent was really below market or perhaps the Landlord just got greedy. Sometimes Landlords do not stay current with the local market. If he had done that, he may not have lost you as a tenant. Tenants and Landlords should both pay attention to the current market when it is time for a lease renewal.
I am a landlord in Palm Beach County. I have taken over management of a building owned by my family. I have been a residential realtor for many years but have limited experience negotiating commercial leases. The former family member who managed the building completely ignored rent escalations and so there are tenants paying far less than they should and some even less than CAM. Needless to say, rent must be increased for many of the tenants (who also now all have expired leases). However, one of the tenants in the building whose rent has not increased and who has been there for approximately 20 years, originally signed a lease with 3% escalations. If those escalations had been applied all these years, the tenant would now be paying an amount per square foot ($25 psf) that is in excess of the average rent achievable in this area (approximately $20 psf according to CoStar). I also have some vacancies in this building for which I am trying to negotiate leases. Because new prospective tenants envision these leases as long-term prospects, I am skittish about how to explain rent increases that the tenant may see as, after several years, being above the going rate of the area. It’s a weird, complicated math formula because there is no doubt that taxes, insurance and maintenance are going up but sometimes areas themselves are stagnant or going down. Any advice on how to address the concerns of potential tenants regarding this? Btw, all the previous leases were written as gross rent with increases plus rent stops on property taxes and insurance after year 1. That is a whole other subject. I find explaining rent stops to these “types” of tenants to be extraordinarily difficult as they are small businesses with owners who are not super-savvy about business. I feel like I “spook” them with my rent talk when it comes to explaining these increases.
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