A rent escalation is simply an increase in the rent payment specified in a lease agreement.
Rent escalations (aka increases, steps, or bumps) are often quoted as a set percentage (e.g. 2% annual escalations), but can also be:
- A flat dollar amount (e.g. $1,000 increase)
- A dollar per square foot amount (e.g. $0.50 per sq. ft.)
- Tied to an index (e.g. increases based on change in CPI)
As is true with just about everything in a commercial lease, rent escalations are negotiable and can vary considerably. The rent could escalate every year, every five years, not at all, or it could even be a condition of some external factor.
Pat’s Pizza Pies (PPP) is leasing a 3,000 sq. ft. space for a pizza restaurant. PPP has agreed to a five-year term with initial base rent of $40.00 per square foot annually, and the landlord proposes 3% annual rent escalations.
The proposed base rent schedule for the initial term looks like this:
Why do landlords care so much about rent escalations?
It goes without saying, but clearly landlords are in favor of rent escalations.
Particularly with long-term leases (5+ years), rent escalations equate to reliable growth in the property’s projected net operating income (NOI); contractual growth in future NOI means that investors will apply a lower capitalization rate (aka cap rate) to the in-place NOI, which results in a higher property value.
What should I watch out for as a tenant?
For obvious reasons, you want to keep rent escalations to a minimum as a tenant. Besides simply negotiating to lower the escalations, here are a few slightly less obvious considerations:
- If escalations are tied to an index, it’s wise to include a cap on potential increases (e.g. not to exceed 3%).
- Be careful about escalations too far into the future – you probably don’t want to experience the wrong side of the compound effect after a 10-year lease has escalated 3% annually.
If you have renewal options, you may (or may not) want to consider resetting to fair market rent at the time of the renewal rather than committing to continued escalations consistent with those specified in the initial term.