What you need to know about the “lease escalation” clauses in a New York City Office Lease
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. 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: 1) A direct operating pass-through of the landlord’s costs to operate or 2) A fixed annual increase. Here is what you need to know about each.
Typically, the newer/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 is how it works. A lease will have a base operating year which is typically the year the lease was executed or the year in which the lease commences (and it may in fact be a blend of 2 different years if the lease starts mid-year i.e. the average of 2024 and 2025). Say the cost of operating the asset to a landlord is $1 million per annum for the respective base year. The lease will outline what the tenant’s pro-rata share of the building is depending on how much space they occupy (a 10,000 square foot tenant in a 100,000 square foot building would be 10%). If a tenant has 10% of the building, and the landlord’s costs to operate increases by $100,000 in a respective year then the tenant’s direct operating passthrough increase would be $10,000. This escalation increases year over year as the expenses to operate increases over time and accumulate over the life of the lease. One other thing to note is it is important to review what is included in the escalation clause. Landlords will often include items in the direct operating clause, like capital expenditures, that a knowledgeable broker and counsel will negotiate out such as administration costs.
The other common method most typically used is called a fixed per annum increase. The per annum increase is more typically used in the smaller and older buildings. In the past when the rents in the $20’s & $30’s in these properties a 3% annual escalation was reasonable. However, now that the rents are in the $40s/ $50’s or $60’s per square foot, a 3% will grow the rent significantly over a long-term lease. A $50 rent at 3% will be $59.70 in year 7.
It is best to ask for a direct operating pass through as rent does not grow as significantly. Many landlords will not agree as the accounting is time consuming. If that is the case, then the goal needs to be to push the escalation to as close to 2% -2.5% as possible.
By way of example- If the costs to operate a building increase by 5% year over year that is 5% of $10-$15 per square foot to actually operate or $0.50-$0.75 per square foot (.05 x $10 or $15). Where a 2.5% escalation of say a $50 per square foot rent equals $1.25 per square foot ($50 x .025).
The math will always be better for the tenant with a direct operating pass through. But for most smaller landlords the per annum increase is must easier to manage from an accounting perspective.
Before you agree to lease terms always ask your broker to provide a financial analysis showing all costs including escalations over the life of the lease.