The Downfalls of CPI Escalations in Commercial Leases
When it comes to signing a commercial lease, there are many factors to consider to ensure a favorable, and financially sound agreement. One particular aspect that healthcare providers often overlook, that should be approached with caution, is the inclusion of CPI (Consumer Price Index) escalators. While landlords may make a strong case as to why you should include a CPI clause in your lease, it is crucial for tenants to understand the potential drawbacks and implications associated with them. In this article, we will explore what CPI is, why landlords favor CPI escalators, and why it’s in the best interests of healthcare providers to have an agent who understands the significance of CPI escalators.
Understanding CPI and its Purpose
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for goods and services. It is used to track inflation and gauge the purchasing power of consumers. CPI is typically calculated based on a specific index, such as the CPI-U (Urban Consumer Price Index), which reflects the spending patterns of urban households. They can also be hyper localized to specific regions or markets around the country.
The Landlord’s Perspective and the Appeal of CPI Clauses
Landlords often include CPI escalators in leases as a means of protecting their rental income against inflation. By tying rental increases to changes in the CPI, landlords aim to ensure that their revenue keeps pace with rising costs and maintains the value of their investment. It is not unreasonable for landlords to want to see some sort of escalation within the lease as real estate is one of the most consistent appreciating assets that a person can own.
But in most cases, the landlord gets a double win with a CPI escalator by stipulating in the lease that the rental increase will be the greater of either: the percentage increase in CPI; or a fixed minimum amount (such as 3%). Meaning they get all the benefit of a high inflation market, and none of the risk (or benefit to you) of a low inflation market.
The Pitfalls of CPI Escalators for Tenants
While CPI escalators may seem reasonable at first glance, tenants should exercise caution and thoroughly evaluate the potential drawbacks before signing a lease agreement. The main reason this is not a fair ask is because CPI has no connection to the appreciation of commercial real estate. For instance, the real estate values have steadily increased over the last 100 years (outside of a small dip here or there, as was experienced in 2008 and a strong surge in 2020), whereas the U.S. CPI over the same time period looks more like an irregular heartbeat.
Key Reasons CPI Escalators are Not in Your Best Interest:
Lack of Predictability: CPI escalators can introduce uncertainty into a tenant’s financial planning. Fluctuations in the CPI can lead to unpredictable rental increases, making it challenging for tenants to budget effectively and plan for future expenses.
Potential for Rapid Increases: In certain economic conditions, CPI may experience sharp increases due to factors beyond the tenant’s control, such as spikes in energy costs or supply chain disruptions. This can result in significant rental hikes that may strain the tenant’s budget and profitability.
Cumulative Impact: Over time, even modest CPI escalations can accumulate and lead to substantial rent increases. Tenants should carefully consider the long-term financial implications of CPI escalators, especially when their business operations depend on stable occupancy costs.
Alternative Rent Structures: Tenants should explore other rent structures that offer greater predictability and control over rental expenses. Most commonly, landlords are willing to accept an escalator that ties rent increases to either a specific percent at a specific period in the lease or a specific per square foot increase at a specified time in the lease.
The Importance of Buyer / Tenant-Only Representation
Navigating the complexities of commercial leases, including CPI escalators, requires expertise and advanced negotiation skill. Engaging the services of a buyer / tenant-only agent, without any conflicts of interest, is crucial in securing the best lease terms and protecting the tenant’s interests. An agent specializing in representing buyers / tenants understands the nuances of commercial real estate transactions and can help mitigate the risks associated with CPI escalators.
For Example:
Let’s take a closer look at the cost differences between two different 10-year leases signed in 2013, each with varying escalator clauses.
In the first lease, the tenant agreed to a 2,500 square feet space at a rate of $25 per square foot, with an annual escalator of 3% or CPI-U for All Urban Consumers (whichever was higher). For the sake of example, we used January numbers for the year over year difference.
In the second lease, the landlord agreed to an annual escalator that would increase the same dollar amount every year. In this example, we used $0.50/sf per year as the escalator.
By comparing these two lease structures, it becomes very clear that the first lease with the escalator based on the higher of 3% per year or CPI results in a much higher (and as importantly, much more unpredictable) lease payment. When compared to the $0.50/sf per year escalator of the second lease, the difference is a $46,101.87 NET savings to the practice.
The most eye-opening thing of all is that with this very common CPI language in the lease, when the inflation was below the 3% mark, the landlord was making almost double the average CPI in annual escalations. But as soon as it hit 8%, the landlord got even more benefit.
This example highlights the importance of carefully considering the terms of the escalator clause in a lease agreement and how it can significantly impact the overall costs for a tenant over an extended period. Working with a buyer / tenant-only agent can help navigate these complexities and negotiate favorable lease terms that align with a tenant’s long-term financial goals.
Conclusion
While landlords may find CPI escalators advantageous for maintaining their rental income in the face of inflation, tenants should approach these clauses with caution. The lack of predictability, potential for rapid increases, and cumulative impact of CPI escalators can significantly affect a tenant’s financial stability and operational profitability. It is essential for healthcare providers to carefully evaluate lease terms, consider alternative rent structures, and enlist the services of a buyer / tenant only agent to ensure a favorable lease agreement that aligns with their long-term business goals.
By making informed decisions and seeking professional guidance, tenants can secure leases that promote financial stability and provide a solid foundation for their business success.
CARR is the nation’s leading provider of commercial real estate services for healthcare tenants and buyers. Every year, thousands of healthcare practices trust CARR to achieve the most favorable terms on their lease and purchase negotiations. CARR’s team of experts assist with start-ups, lease renewals, expansions, relocations, additional offices, purchases, and practice transitions. Healthcare practices choose CARR to save them a substantial amount of time and money; while ensuring their interests are always first.
Visit CARR.US to learn more and find an expert agent representing healthcare practices in your area.