CPI Reforms Could Affect Commercial Real Estate
In December 1996, a Senate Finance Committee-appointed commission of economists suggested that the U.S. Consumer Price Index (CPI) overstates cost-of-living increases by about 1.1 percentage points annually. The CPI currently is rising at an annual rate of 2.9 percent; however, if the commission's estimates are accurate, the "true" annual inflation rate is closer to 1.8 percent. The range of plausible values for the overstatement, according to the commission, is from 0.8 percentage points to 1.6 percentage points per year.
Because commercial leases are negotiated on a long-term basis, they tend to have rental escalations that are triggered during specific times during the lease. Owners and tenants negotiate these escalations, which can be based upon a fixed schedule or a change in the CPI. Consequently, changing the methodology for measuring the CPI can potentially affect a commercial project's financial performance.
Within the lease, the tenant pays the owner for the space rental. However, the form in which the tenant compensates the owner for expenses varies by lease structure. With a full-service gross lease (FSG), the monthly rental payment to the owner covers both space rental and expenses. However, in a triple net (NNN) lease, the landlord passes its pro rata share of expenses through to the tenant.
When examining the space rental portion of both NNN and FSG leases, the clear winners will be tenants with CPI-indexed escalations. Assume that the proposed change in the CPI would decrease CPI growth from 3.0 percent to 1.9 percent. Over the course of a 10-year lease with a starting base rent of $1,000 per year, total rent paid under a 1.9 percent annual escalation versus a 3.0 percent escalation is $10,900 versus $11,464—a 4.9 percent decrease. Even discounting the value of the future payments by 8 percent, a 2.8 percent differential remains. Consequently, some tenants would experience a windfall if the CPI was adjusted in the early years of the lease. Those who have negotiated fixed increases in their lease rates would not experience this windfall.
In a CPI escalation lease, the owner would experience slower-than-expected increases in the space rental component, while the tenant would experience a windfall until the lease expires. On subsequent leases, the owner would raise the space rental for the new lease to account for the slower rate of CPI escalation. As a result, new tenants or renewal tenants would have to make up for the lower CPI-based lease escalations through higher base rents.
Regarding the expense portion of the lease, some tenants will fare better than others. To cap the possible expense escalation level, many tenants have negotiated expense escalation clauses prohibiting the owner from raising their expenses beyond a certain percentage of the change in the CPI. Tenants who have such an escalation ceiling in their leases will be the clear winners. Tenants who have expense escalations tied to the actual increase in the expenses may be helped indirectly by the lower CPI, because many building owners tie maintenance and custodial service cost increases to changes in the CPI. Lower CPI escalations could moderate the level of cost increase that will be passed through to tenants in the form of lower-than-expected increases in the expense portion in a NNN lease.
In an FSG lease, the owner would benefit if the expense escalations were based on a set percentage per year, unrelated to the CPI. In this case, the fixed schedule of increases most likely would have been negotiated based on past increases in the current CPI. The differential between the slower rate of increase based on the adjusted CPI and the negotiated escalation would be pocketed by the building owner.
On balance, the lower CPI escalation will benefit tenants at the expense of owners because planned increases in rental revenue tied to the CPI will be lower than expected. As explained earlier, in only one case will the CPI adjustment benefit the owner; however, such a case occurs relatively infrequently. In any event, the windfall to tenants is a short-term victory as building owners would take into account the impact of lower CPI escalations when negotiating new leases.
Although CPI reform currently is in proposal form, it has strong bipartisan support because of the dramatic reduction in entitlement spending that would result from a lower CPI adjustment. When negotiating new leases, building owners should assess the impact of potentially slowed CPI escalations on their cash flow and adjust the base rent accordingly or establish fixed annual increases that are not tied to the CPI.