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Commercial leases for office, retail, and other commercial space typically contain two rent components: (i) a base rent calculated by multiplying the rental rate per square foot by the rentable area of the leased space, and (ii) a common area maintenance (CAM) charge calculated by multiplying the tenant's pro rata share of the total leased space in the building by the amount of operating expenses, such as utilities, repairs, maintenance, taxes, and insurance, incurred by the landlord. Usually the base rent increases annually by an agreed upon "escalator."
For many years, the escalator commonly used for rent increases was the Consumer Price Index (CPI). The CPI, which officially originated in 1919, is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for major groups of consumer expenditures, such as energy and food and beverages, housing, and medical care. Indexes are available for geographical census regions' two population groups: a CPI for All Urban Consumers (CPI-U), which covers approximately 93% of the total population, and a CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers 29% of the population.
The particular CPI that has been used for rent increases is the CPI-U, All Urban Consumers, U.S. City Average, 1982/84=100. In 1988, the reference base for the CPI was changed from 1967=100 to 1982-84=100 to coincide with the updated expenditure information prepared for the Bureau of Labor Statistics for 1982, 1983, and 1984. The calculation of annual escalation is straightforward; it is determined by subtracting the CPI for the immediately prior lease year from the CPI for the current lease year and multiplying the result by 100.
During approximately the last 20 years, the use of the CPI has diminished for two key reasons. First, calculating annual rent increases using the CPI can be administratively burdensome for both landlords and tenants; second, and most significantly, the rate of inflation has been relatively low and stable. Core inflation averaged 2.15% per year between 1995 and 2022. Accordingly, landlords and tenants have opted to use a fixed percentage, e.g., 2%, as the escalator.
But over the 12 months from January 2021 to January 2022, the CPI-U rose 7.5%, not seasonally adjusted. This is the largest 12-month increase in 40 years. Food prices increased 7%, while energy prices rose 27%. This reflects an inflationary trend that began several months ago, which analysts projected would diminish in the latter part of 2022. The horrific invasion of Ukraine and the effects on energy prices, coupled with ongoing supply chain issues, however, has made these projections more uncertain. But the harsh reality is that the rate of inflation may continue to be much higher than the 2.15% annual average rate since 1995.
In view of these changes, landlords now need to reconsider the escalator to be used for rent increases in new leases and lease renewals, including the possible re-utilization of the CPI, either alone or in conjunction with one or more other escalators. Further, landlords locked into long-term leases with a fixed percentage rent escalator that is below the rate of inflation may face the challenge of seeking ways to renegotiate these leases within the parameters of contract law. Conversely, tenants considering entering into new commercial leases are now confronted with the challenges of negotiating a rent escalator that does not make the lease too financially burdensome and the prospect of landlords seeking to renegotiate rent escalators.
The real estate team at Norris McLaughlin, P.A., has extensive experience assisting both landlords and tenants in commercial lease transactions of all types and sizes, and is prepared to assist in these challenging times.
