Rent escalations might seem like a fundamental part of being a tenant, but they don't have to be. While occupancy costs typically go up along with inflation, you can protect yourself from unreasonable increases in rents. Some of your protection comes from having a well-negotiated lease document. More protection can come from having a strategy for controlling operating expenses mapped out. Here are three tips for reducing rent escalation expenses:
1. Cap or Eliminate Rent Escalators
Some leases in the single-tenant net-leased space are structured to be flat for decades. If you're occupying build-to-suit properties and engaging in sale-leaseback transactions, a flat rent could be within reach. Structuring a flat lease might limit the cap rate you achieve at disposition, but lower sale proceeds might be worth it to limit your future expenditures.
Another strategy is to sign shorter leases that are flat. If you do this, you may have a 3-5 year period during which you pay the same rent. However, unless you are also able to negotiate flat options, you will probably have a single, large escalator when the option comes due. Nevertheless, you could come out ahead by doing this.
When a landlord insists on regular rent escalations, offer him an escalator tied to the rate of inflation with a cap. Capped CPI escalators are actually more tenant-friendly than flat rent escalators. With a capped escalator, your rental upside is limited - frequently to 2 or 3% per year, but if inflation is lower than the cap, you get the lower increase.
2. Sign Net Leases
A net lease might seem like it's more landlord favorable since it transfers the responsibility of paying for operating expenses to you as a tenant. However, given that many gross leases are structured with base years or expense stops, you still end up paying for increased expenses.
In addition, when a gross lease has a 3% escalator, it applies to the entire rental payment. A 3% escalator on net lease space only applies to the rental portion, letting your operating expenses float with the market or with your ability to manage them for savings. Ultimately, 3% of $35 net is a lower increase than 3% of $51 gross.
3. Manage Operating Expenses
The other way to deal with lease escalators is to use aggressive management of your operating expenses to balance them out. This strategy works best when you sign a net lease. It also presupposes that you are in a space where you have the opportunity to both control your operating expenses and benefit from any savings that you generate.
While inflation makes your operating expenses go up, your management can help to balance that out. Here's an example:
- Year 1: You might plan to rebid vendor contracts for janitorial service, coffee and water and the like to achieve savings.
- Year 2: You could install window films to reduce heating and cooling expense.
- Year 3: You could install high-efficiency lighting to reduce electric usage.
- Year 4: Use your scheduled capital equipment replacement to turn power-hungry desktop computers into more efficient notebook computers.
Planning these upgrades over time might not completely eliminate the impact of rent increases, but a forward-looking strategy can blunt them. Shed the operating expenses that impact your business and learn how to improve your EBITDA.
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