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What A Dental Real Estate Tenant Needs To Know About Rent Escalation Clauses (Part I)

What A Dental Real Estate Tenant Needs To Know About Rent Escalation Clauses (Part I)

6/17/2019 9:34:43 AM   |   Comments: 0   |   Views: 14

Unfortunately, commercial leases have something in them that you never had to worry when you were buying your home.

And that's rent escalation clauses.

These clauses allow an owner to increase your rent at regular intervals. Sometimes, tenants and landlords argue over whether there should even be one. But without one, your landlord could end up losing lots of money.

That's because rent escalation clauses ensure that the landlord's profit margin won't be eroded by spiraling inflation and skyrocketing operating costs. Not so long ago, building expenses rose so gradually, an owner could catch up by increasing the rents of new tenants as they moved in.

However, costs now are so wildly unpredictable that most landlords feel they need some sort of protection in the form of escalation clauses. They can't pass these costs to you unless the lease says they can. 

Base Year

To understand rent escalation, you need to know how negotiating parties calculate the base year. The base year is the baseline against which all future rent increases will be measured, and it's designed to protect landlords from excessive annual increases in operating expenses.

For the first year of your lease, the owner pays all operating expenses. And then, whatever operating expenses were incurred the first year becomes the annual cap on the landlord's contribution to operating expenses.

That means, if there's an increase in operating expenses of $120,000 during the second year, you'll have to reimburse your landlord your prorated share of that cost. 

When figuring out rent escalation clauses, you need to pay attention, so the landlord doesn't manipulate base year operating expenses to squeeze more cash out of you down the road.

One way the base year designation is misused is when a landlord defers major CAM expenses until after the base year. This isn't exactly ethical, but it is legal.

Gross-Up Clauses

 In the world of commercial real estate, wildly fluctuating occupancy rates can financially devastate a tenant unless there's a gross-up clause in the lease.

You might have moved into your building when it was only 50% occupied. The landlord uses this first year as the base year. And then, it fills up after your first year of tenancy comes to an end. These additional tenants drive up operating costs.

So, your base year had low operating expenses. Subsequent years don't. This means you're unfairly burdened with an escalation in what you pay for rent.

Commercial leases solve this problem by including a gross-up provision. This allows a landlord to project costs for a building with a lot of vacancies as if it were fully occupied.

By including a gross-up clause in your lease, you'll be protected from spikes in variable expenses like utilities as the building fills up.

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