Annual Escalations in a Commercial Lease. What You Need to Know.
The escalation clause is a provision in a lease that allows for annual increases in the rent. The rationale behind the clause is so a landlord can defray the increasing costs to operate, maintain, and service the building and continue to provide the same level of service throughout the term of a lease. This clause specifies the method for determining the increased rental amount.
Why Escalation Methods Matter
This is the IMPORTANT part of the blog. The escalation method utilized is critical, particularly over a long-term transaction, as the escalation can have a significant impact on the rent. There are two main ways that the tenant participates in paying their share of the increase:
A direct operating pass-through of the landlord’s costs to operate
A fixed annual increase
Here is what you need to know about each:
1. Direct Operating Pass-Through
Typically, newer and more modern full-service properties use a direct operating pass-through. This method is most fair to the tenant, as it is based on the actual costs of operating the asset to the respective landlord, which a landlord will invariably always try and keep down whenever possible.
Here’s how it works:
A lease will have a base operating year, typically the year the lease was executed or commences (it may even be a blend of two years if the lease starts mid-year, e.g., an average of 2024 and 2025).
Say it costs $1 million per annum for the landlord to operate their asset during this base year. If a tenant occupies 10% of the building (e.g., 10,000 sq ft in a 100,000 sq ft building), their pro-rata share would be 10%.
If operating costs increase by $100,000 in a given year, then the tenant’s direct operating passthrough increase would be $10,000 (10% of $100,000).
➡️ For more insights into how operating costs impact tenants’ financial obligations, read Deal Economics in a NYC Lease: What You Need to Know.
This escalation increases year over year as expenses accumulate over time. It’s important to review what’s included in the escalation clause—landlords often include items like capital expenditures or administrative costs that should be negotiated out by knowledgeable brokers and counsel.
2. Fixed Per Annum Increase
This method is more commonly used in smaller and older buildings.
Historically, when rents were in the $20s–$30s per square foot, a 3% annual escalation was reasonable.
However, with rents now in the $40s–$60s per square foot, a 3% escalation grows rent significantly over long-term leases. For example:
A $50 rent at 3% annual escalation would grow to $59.70 by year 7.
➡️ For tips on negotiating favorable lease terms for smaller buildings, explore Why Length of Lease Matters.
Tenant Strategy
It’s best to ask for a direct operating pass-through since rent doesn’t grow as significantly over time. Many landlords may not agree because this accounting method is time-consuming. If that’s not possible:
Push for escalations closer to 2%–2.5% rather than 3%.
For example:
If building costs increase by 5% year over year ($0.50–$0.75 per sq ft based on $10–$15 per sq ft operating costs), this is still lower than a fixed escalation of 2.5% on $50 rent ($1.25 per sq ft).
➡️ For guidance on evaluating lease escalations as part of your overall occupancy costs, check out How Long Does It Take to Find a New Office Space in New York City?.
The math will always favor tenants with direct operating pass-throughs; however, smaller landlords often prefer fixed annual increases due to easier accounting.
Before agreeing to lease terms, always ask your broker to provide a financial analysis showing all costs—including escalations—over the life of your lease.