4. WILL THE MONTHLY COSTS RISE OVER THE TERM OF THE LEASE?

The base rent negotiated in the typical commercial lease is only the beginning of determining occupancy costs. The additional costs described in the escalation clauses are designed to protect the owner's fixed income from increases in building expenses such as operating costs and taxes, as well as to declining real return values caused by inflation. At times it is also a profit center for the landlord.

There are generally four major categories of escalation clauses: additional rent, real estate taxes, energy costs and code compliance.

Additional rent
The escalation clause in a lease is typically referred to as "additional rent." It is this clause which creates the most confusion and has spawned the greatest variety of formulas. Following are the four types.

Fixed annual percentage
This cost escalator is a flat rate of increase every year or every few years. For example, prior to signing your lease you could agree to pay a 3% increase every year. An advantage to this type of escalator is that it can provide your organization with more predictable expenses, providing certainty in budgeting and planning. A disadvantage is that it may be difficult to negotiate a favorable rate, as both you and the landlord will be taking a gamble on how much costs will actually increase.

Direct operating expenses
In the Pass Through ("Open Book") Method, you pay your proportionate share of the difference between the current year's operating expenses minus the base year's operating expenses. Each year, the landlord presents his tenants with a statement on the costs of running the building.

Questions which need to be addressed are:

1. What is the base year for the operating expenses?
2. What factors are included in the operating costs of the building?
3. Are capital expenses included in operating costs? Brokerage commissions? Legal fees? Tenant work? Will the rent be reduced when labor saving devices are introduced?
4. Does the base amount of the operating costs reflect actual expenses?

Porters' wage
Widely used and initiated in the late 1960's, this escalation mechanism is based on an index tied to wage rates for maintenance and operating personnel. It is generally expressed in terms of "penny for penny" (.01 - .01). This escalation is tied to the labor contract negotiated every three years between Local 32B and the Realty Advisory Board of Labor Relations, Inc. Simply put, if the labor contract calls for a $1 per hour wage hike in a given year, and the escalation calls for .01 - .01, the increase in rent is $1 per square foot.

Questions which need to be addressed are:

1. How is the base year determined?
2. AAre fringe benefits included? Which fringe benefits are included and at what rates?
3. Can we negotiate a rate less than .01 - .01?
4. Is there an additional fuel adjustment provision?

Consumer Price Index (CPI)
With this escalator, your yearly increase in escalation charge is determined by the yearly increase in the Consumer Price Index multiplied by the annual rent; this is cumulatively compounded every year.

Questions which need to be addressed are:

1. What type of CPI is used? (U.S. City Average; specific regional or city averages; wholesale price index?)
2. Is base pegged for specific month or average for years? (Average preferable for tenants in majority of cases.)
3. Does formula compensate for portion of CPI increase paid for separately by tenant in tax escalation clause?
4. Will the landlord agree to a fraction of the percent of increase in the CPI?
5. Will the landlord agree to cap the percentage increase in the CPI?

Real estate taxes
The real estate tax amount for which a tenant is responsible may also increase over the term of the lease.

Questions which need to be addressed are:

1. What is the base year for real estate taxes?
2. How is the tenant's proportionate share determined?
3. Is the landlord using a fixed dollar amount as a base?
4. Is there a target assessment?
5. Was the building sold recently or does the landlord have any future plan in that regard?
6. What is the tax history?

Energy costs
Energy cost increases are sometimes passed along to tenants. In negotiating such an escalation clause, consideration must be given to determining whether or not the building is covered for utility increases in other escalation clauses.

Code compliance
Many landlords will try to pass through to tenants the cost of complying with codes such as upgrading of fire and safety systems, maintaining building facade and The Americans with Disabilities Act.

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