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A primer on escalations.

Escalations represent a landlord's opportunity to recover from tenants the increases in operating expenses used for the maintenance and operations of the property they occupy. In this fashion, the landlord will maintain a reasonably fixed profit margin on each tenant's respective lease transaction throughout the term of that specific lease. Although tenants frequently try to eliminate or minimize escalations, the concept is almost universally accepted. It is very rare to find a recent lease without some sort of escalation provision included within its terms. If properly calculated and administered, the escalation concept is an equitable way to distribute operating costs.

There are many different ways to effect an escalation provision in a lease document. This discussion will not seek to recommend any specific version, but will review in general those basic types that will be found in the majority of the transactions between reasonably sophisticated landlords and tenants. The actual provision utilized in a specific transaction should be created to respond to the economic terms of the lease.

Net or Gross?

There are two primary types of leases when it comes to a discussion of escalations: net leases, in which the tenant is responsible for all operating and some or all capital costs; and gross leases, in which the tenant is only responsible for increases in operating expenses above some predetermined base. Although the escalation provisions in both types of leases accomplish essentially the same purpose, there are certain situations where one may be preferred over the other.

Net leases are frequently used for industrial properties, especially when there is only one tenant in the facility. In these cases, it can clearly be shown that the charges incurred for operations have only one beneficiary. Some office markets, however, also use the net lease format because it allows the landlord to quote a lower base rental rate. This can create some confusion for tenants who are comparing different properties' rental rates. For example, the actual occupancy costs for a $10 per square foot (psf) net lease is going to be much higher than for a $10 psf gross lease. Tenants must be aware of the differential to be able to make a sound financial comparison.

Gross leases can be escalated using many different methodologies. There are, however, four basic methodologies that are currently in use.

* A stop is the escalation method in which a fixed dollar amount for operating expenses is established as a landlord's obligation, with all expenses incurred above that point being the tenant's responsibility. The stop does not need to be set at the expected current level of expenses. It frequently is set at a point higher if the tenant wields great negotiating strength, or lower if the landlord has the upper hand. If set at a lower amount, the tenant would be obligated to pay escalations immediately. At a higher amount, the tenant may never have to pay escalations if expense growth is kept under tight control.

* A base year sets the landlord's obligation as the sum of the expenses incurred and allocable to a designated calendar or fiscal year. A tenant would pay for increases in operating expenses over the amount established for its base year. It should be noted that using a fiscal year creates an extra bookkeeping burden as each tenant will have what amounts to an unique and individual comparison basis. The calendar-year method is recommended if there are more than a few tenants to track so that a common comparison basis can be used. If the current year or a future year is selected as the base year, the actual amount of the landlord's contribution will not be known until the base year is over. At that point, the mechanics of escalating increases are identical to those of a stop.

* A cost-of-living increase uses a mutually agreed upon reference gauge, usually an accepted government index such as the Consumer Price Index (CPI), to determine the amount by which the base rent will increase. This amount may or may not result in the landlord fully recapturing actual increases in cost. Any increases of expenses above the index rate will result in costs increasing faster than the recovery permitted by the growth of the index. By exercising strict cost containment efforts, however, a landlord may improve the bottom line return of a lease by increasing the marginal profit on that lease.

* The fixed increment is the final method for implementing escalations. It is entirely coincidental if this method generates an escalation charge that equals a property's actual cost experience. However, because it does provide for a definite, predictable rent charge for the tenant, it does have its adherents. Much as with the cost-of-living method, a landlord may be able to improve on the bottom line by running the property more efficiently.

Grossing Up

Stops and base years usually include a provision that permits a procedure known as "grossing up." This procedure seeks to stabilize the escalatable costs so that they accurately reflect the landlord's actual cost to operate the occupied portions of the property. Although this process is not a recent innovation, it still causes significant confusion for many tenants and landlords.

When properties usually maintained occupancies of 90 percent or more, grossing up was not really needed, and its use was seldom provided for in leases. With the downturn in most markets that occurred in the late-1980s, landlords found themselves with their buildings having very large vacancies. Because variable costs dropped with occupancy, a property would cost less to operate on an aggregate cost basis, and apparently less on a per-squarefoot basis as most leases provided for operating expenses to be divided by the fixed area of the property.

Unfortunately, the cost for each occupied square foot typically increased. Without a gross-up provision, landlords lost the opportunity or the right to collect for these increases. Current lease language technology generally ensures that a gross-up provision is in place. (See sidebar).

The actual process to gross up operating expenses can be quite complicated, which is why many have difficulty with the application of this technique. The best and most fair approach is to review each line item of operating expense and determine if it has been impacted by vacancy. Janitorial services are the most obvious charges in this category A cleaning contractor will provide a vacancy credit for empty space that is not serviced. A gross up of this charge will effectively eliminate this credit for escalation purposes to establish a true full-building cost for janitorial services.

After all operating expenses have been adjusted appropriately, the resulting total expenses will likewise represent a more accurate full-building cost, which can then be applied on a per-square-foot basis or on an aggregate-cost basis for escalation purposes. Care must be taken to ensure that the grossing up is implemented on a consistent basis from period to period. Since relative vacancies during the lease term do not affect the calculations, grossing up is not applied to those escalations utilizing a cost-of-living or fixedincrement methodology.

Percentage Rents

Like grossing up, a tenant's percentage share is an important calculation to make. Used primarily with stop and base-year escalation methodologies, this percentage determines a tenants portion of the actual increase in operating expenses. The traditional way to derive this percentage is to divide the area of the tenant's demised premises by the total area of the property. This method generates the most equitable calculation of percentage share. Some leases, however, use the tenant's area for the demised premises divided by the total actually leased. This is an attempt to gross up using the back door; it invariably resulted in a higher charge to the tenant than would otherwise be warranted. Another approach is to understate the size of the property so that a fully occupied property would generate escalations of more than 100-percent of the applicable charges. As with all financial matters, disclosure is required to avoid the perception of improper activities.

Exclusions

Stops and base years invariably have verbiage identifying those charges that are excluded from consideration as permitted operating expenses. Frequently, the content and makeup of these exclusions is affected by regional biases. Nevertheless, there are several exclusions which are fairly typical. Leasing commissions, tenant improvements, and capital improvements are viewed as landlord costs not directly associated with the operation of the property. Other landlord costs such as income taxes and corporate costs are also excluded, as are any charges the parties specifically agree to exclude.

Capital expenses are probably the most common expenses cited as non-escalatable. An exception is capital improvements that result in a reduction of operating costs. In such cases, a landlord is usually permitted to escalate the cost - up to the amount of the annual savings - until the total cost is recovered. Thereafter, the tenant benefits from the reduced level of expenses resulting from the landlord's previous investment.

Another form of exclusion is setting a cap that limits the amount of escalatable charges permitted, expressed either as a percentage increase over prior periods or as a fixed dollar amount. An astute landlord, unable to reject a demand for a cap, will usually attempt to limit the cap to controllable expenses, such as services which are bid and contracted to independent vendors. Real estate taxes, utilities, and sometimes insurance premiums are viewed as uncontrollable costs whose fluctuations cannot be regulated and would have serious negative ramifications to a landlord if their increases were artificially limited by a cap.

When faced with a cap, the landlord should attempt to have the calculation work on a cumulative basis so that a good year, i.e., one with low increases, can offset the impact of a bad year, i.e., one with increases exceeding the cap limit. This approach still allows the tenant to calculate its worst-case scenario for occupancy costs with a high degree of accuracy.

Maintaining the Base

Finally, it must be emphasized that the escalation provision must ensure that in no event will the tenant's base rent be reduced from that established by the lease. It is acceptable that the amount of escalation to be paid by a tenant will increase and possibly decrease from year to year, especially under the stop- and base-year methodologies. However, without specific verbiage prohibiting the allocation of cost reductions to the base rent, a tenant may be justified in demanding a reduction in the base rent if, for example, in the year following its leasing space in a building, the CPI drops by 2 percent or if a comparison year's operating expense level is below the stop or base year.

Operating expense escalations are not a glamorous part of managing real estate. However, they could mean the difference between generating a return on the owner's investment or not. A property manager has an obligation to both landlord and tenant to implement an escalation program in a reasonable, accurate fashion. It is necessary to have a clearly worded escalation clause in the lease and ensure that the calculations adhere completely to the terms of the clause.

Errors and poor administration of the escalation clause can have serious and lasting negative impact for the property with both existing tenants and new prospects. Tenants expect to be treated fairly. If their perception is that the landlord has been fair, escalation charges will not be an issue. Selection and proper implementation of the most appropriate escalation methodology will go a long way to minimizing the potential for problems as the lease matures.

Sample Escalation Clause

There are many different ways to work a gross-up provision. A simple and straightforward example is as follows:

Partial Occupancy: If the Property is not fully occupied during any calendar year of the Lease Term (or partial year of the Lease Term), as the case may be), an adjustment shall be made in computing Operating Costs for such year (or partial year, as the case may be) to the amount that, in Landlord's. reasonable judgement, would have been incurred had the total rentable area of the Property been fully occupied during that year (or partial year, as they case may be)."

It should be noted that occupied area, as opposed to leased area, is the important factor for grossing up. The gross-up can be made to 100 percent, 95 percent, 90 percent, or any other occupancy level agreed to by the parties. Further modifications, such as identifying fixed and variable costs, are also possible.

Nicholas E. Stolatis, CPM[R], RPA, holds the position of Director-Asset Management at Teachers Insurance & Annuity Association (TIAA), where he is responsible for asset management of the Wholly Owned Real Estate Department's Northeast Region. His team of four asset management professionals oversees a portfolio with a market value in excess of $1 billion consisting of office, industrial, retail, and residential properties with a total area of 9.5 million square feet.

He has been with TIAA for 15 years and has been directly involved in asset management for 20 years.

Mr. Stolatis. is very active in the Greater New York Chapter of IREM where he is currently serving on the Executive Committee as Vice President of Activities. He has previously served as its treasurer, president-elect, and president. He was named Certified Property Manager of the Year in 1991. He is a facilitator for IREM's Course 800, "Ethics in Real Estate Management" and is an instructor in the BOMI Institute's RPA designation program.

Teachers Insurance and Annuity Association of America is part of TIAA-CREF, the world's largest private pension system, currently with more than $230 billion in assets under management. TIAA has in excess of $100 billion in assets under management including approximately $27 billion in mortgage and real estate investments.
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Author:Stolatis, Nicholas E.
Publication:Journal of Property Management
Date:Nov 1, 1998
Words:2275
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