Escalations in leases: mixed blessing.

Escalations in leases: Mixed blessing 

Most commercial and retail leases in New York City have some form of built-in rental escalations. Real estate taxes, porter wages, operating expenses and ties to the Consumer Price Index head a menu of options available to tenants which brokers say are unique to New York City's rental market. Some buildings must also resell electricity to tenants. Owners maintain they are only trying to keep ahead of their costs even though critics say certain escalations could be profit centers. Even so, rapidly rising costs have made escalations a double-edged sword for both property owners and their tenants.

Escalations are a fact of life in New York, said David Solomon, executive vice president of Harper-Lawrence, Inc. But he cautioned, their success also depends on how strong the market is. "It's a unique approach that very few other places have, but it's a stopgap for the loss of purchasing power to the landlord or the developer," he explained. "The landlord is trying to maintain his buying power."

It is uncommon to not pay escalations, Solomon noted, except for a short-term sublease. Escalations are very rarely omitted on a long-term basis, he added.

Attorney Peter L Malkin, chairman of Wien, Malkin & Bettex, said all leases in New York include real estate tax escalation pass-throughs and some contain other escalations. "What other kinds of protections are there for the owner against inflation?." he said. "No one can afford to enter into a long-term arrangement with a fixed rent with everything else going up."

Owners Suffering With Tenants

Property owners do not generally update the tax base when renewing, said Donald H. Tack, vice-president of Don Alan Realty Associates, Inc. They do, however, take into consideration that they are giving a lower rental for the renewals. "All a landlord wants is to have the same purchasing power today that he had two, three or four years ago," Tack noted. "So he puts in a 3 or 4 percent increase and hopes it keeps pace with inflation and he passes the taxes along to the tenant."

Tack, who primarily handles Long Island City industrial property, claims the owner suffers the worst when he loses his tenants and begins a new tax base. "Then mayor Dinkins becomes his partner," he said.

Edward T. Brock, director of retail leases for Williams Real Estate, Inc., said escalations can be a problem for tenants, particularly if a building was sold and the assessment was raised. "They keep asking us to pay for Mayor Dinkins' mistakes," Brock complained. "There's only so much you can pass along. It used to be when the rent was too high, the tenants felt like they were working for the landlord. Now they have two people to point a gun at."

Newmark & Co.'s Glenn H. Isaacson said there are so many different escalations they are "definitely" putting tenants out of business. "If it's not putting them out of business," he added, "it's forcing them out of New York."

Sale and Reassessment Lifts Taxes

Where there is a sale of the property, the next year the real estate tax assessor will automatically fix the increase at 45 percent of the sale price, said Sam Schneeweiss, a partner with Becker, Ross, Stone Destefano & Klein. "In many cases that represents a tremendous boost to the tenant," he said. Schneeweiss, who represents both owners and tenants, said the tenants would like a clause to the effect that, in the event of a sale, any portion of the increase in real estate taxes due to the sale would not be put on the "backs" of the tenant. "But a prospective purchaser will not want it," he added, and it is very unusual to be allowed into a lease.

Some Class "B" loft buildings with low tax bases, Isaacson concurred, were converted to office buildings and were then reassessed. "Taxes went from $1 to $3, $4 and $5 a square foot; all of that borne by tenants. Basically, it's a big hit on a tenant who is marginal."

The secondary office space market in Manhattan is hurting because over the years the escalations have become a major portion of the rent. In an "B" office building, Isaacson said, if a tenant gets a $3 or $4 escalation on a $16-a-square-foot rent, it is a 20 percent increase. He said the "A" buildings are not as bad off because they are assessed higher, and obtain higher rents, so even if there is an increase of $4, it might only be a 10 percent increase in rent. "It just gets folded into someone's overhead," Isaacson noted. "But for a small guy, the rent makes up 30 to 40 percent of the overhead."

Tack added, "The tax escalations are bad for the owner but worse for the tenant. The owner has the uncomfortable position of going to a tenant and giving him a tax bill. "Tack said he will be soon be giving one tenant the equivalent of two and one half months rent for a six-month tax bill. "He has been a tenant since 1975 and will bear the brunt of what is going on," Tack explained. The owner in the final analysis will suffer, Tack said, "but it is the tenants who will be hit with a tremendous tax increase."

Not A Profit Center

Nobody makes money on direct operating expenses, Isaacson said, such as insurance and heat, which, he said, are all computed generally on very fair formulas. "There are some older leases with more than a penny-for-penny increase on porter's wages; they are making a killing," he said.

These older leases could also include "fringes" (fringe benefits for porters) which, Isaacson said, were fair at the time they were negotiated. "Now it is probably a little in the favor of the owner," Isaacson admitted. Most of the tenants can live with it, he said, because it might only amount to 20 cents a year.

Currently, a porter's wage formula without fringes is what is generally being achieved, Isaacson said. "This allows him to make a little money on the escalation and makes him a little bit whole," he said. "But the owners are losing their shirts on what the building is costing."

For industrial warehouse and factory office space, Tack said, there are no profit centers in any escalations. "There are no little hidden goodies," Tack added. "If we get a water bill and a sewer bill we pass it right along to the tenants."

Schneeweiss said when these escalations started, it was a way owners had of increasing their income. "They developed a philosophy that they would get the same dollars, five years down the road, as at the making of the lease," he said. "Their attitude was, if I'm paying $10,000 now in 1991 for real estate taxes, since I want to receive the same rental from the tenant, the tenant must absorb any increase."

Years ago, Schneeweiss said, tenants were able to get a cap on property tax escalations. Once the real estate taxes started escalating dramatically, he said "that went out the window" until the recent recession. Now, some commercial tenants with a strong bargaining position could get a cap in some instances, he noted.

Electric Resale A Problem

In a recent letter to The New York Times, Malkin said about 1,000 buildings were induced by Con Ed and the previous Public Service Commission "to promise the facilities for redistributing electricity at great expense, by the provide that they create a profit center..." The letter, which opposed a then pending legislative proposal to limit electricity charges by landlords to 12 percent above what is paid Con Ed, would actually, Malkin stated, result in resale at a loss. The letter went on to say that rate changes and time of day rates have substantially diminished what was intended to be a profit center.

Most new buildings Malkin said, opt for direct Con Edison connections to the tenants because it does not pay for a property owner to be responsible for supervision of the resale of electricity. "The point is, that it's not a great profit," Malkin added in a telephone conversation.

Ralph W. Felsten, Malkin's law partner and an expert in commercial leasing, gets livid when the words "profit center" are used. "Taxes and expenses are not a profit center but a pass--through," he insists. "With a proper basis, if I got 100 percent back (of expenses) for 100 percent of the tenants, it's still not a profit center. There are vacancies, there are deadbeats, every one has a different base year. It's not only not a profit center, it doesn't even get me back (to the original rental amount with costs and inflation added)." For this reason, Felsten advises including both some kind of operating expense escalation and Consumer Price Index escalation to protect the owner from the "ravages of inflation."

From an owner's point of view, Felsten said in an article for the Real Property Law Section Newsletter, the operating expense escalation does not operate effectively because of disputes, differing based years and defaults by tenants. The porter's wage or Consumer Price Index adjustment of rent, when joined with tax escalations, better protect owners against inflation and preserve the rental income, he added.

About 20 years ago, Felsten explained, studies found that the porter wages were roughly changing the way all expenses were changing, and to avoid disputes over fringe benefit computations, the porter's wage, in most leases, became a penny-for-penny increase. Over the years, the porters wages became not as nearly correlated as they had been to operating costs. "It's a gamble on the part of the landlord," Felsten said, as to which formula an owner should use.

Schneeweiss said the owner "should fish or cut bait. Either he gets the operating increase of the CPI, but not both. In some cases," he added, "you have no choice but to take it."

One broker, who asked not to be identified, said owners can also calculate escalations far in excess of costs. "But they very rarely do," he admitted, especially when accounting for operating expenses.

But another broker, who also spoke on condition of anonymity, said the escalations can be tricky and wondered if "operating costs" sometimes include the owner "going out to lunch at the Four Season like some of them do."

Real estate tax escalations, the first broker said, should be a forthright calculation based on the tax bills issued by the city and the occupancy. But, he admitted, sometimes when you add it up, all the tenants exceed 100 percent of the bill.

Schneeweiss said on lower Broadway, he represented a prospective tenant of a store, and, although the store comprised about five percent of the floor of the entire building, the owner insisted on a 17 percent increase. The owner's argument, Schneeweiss said, was that the store space is more valuable and generally any increases in taxes would come when a new tenant comes in and improves the space. When Schneeweiss polled other tenants he found the owner was getting between 175 percent to 200 percent of the increase. Although, Schneeweiss said, the owners may say they never achieve 100 percent due to differing bases and vacancies, "To me, the variation is always in favor of the owner."

Solomon said an owner will usually refund overcharges in real estate tax escalations if the building obtains a reduction, but noted that it would depend on the way the lease is worded.

One attorney, however, said some owners do not want to pursue assessment reductions after the bill is paid because they would have to refund more than what they paid out.

Tack said he sees a lot of tenants just giving up, saying they cannot afford to operated. The ones who can pay, he added, are moving out because there are good deals to be made just outside of the city on Long Island, in Westchester an New Jersey. "When the city wakes up to the fact that the tenants can't afford the increase, it will be too late," he warned.