Many traditional commercial leases are structured with a tenant paying a set rent with consumer price index (CPI) escalations plus a pro-rata share of any property tax increases over a base year. On the face of it this structure appears fair and reasonable. The landlord keeps pace with expense increases and property tax escalations. In reality, the landlord gets the better end of the deal.
Lets say you have a $20 per square foot rent with CPI annual increases and a pro-rata share of property tax increases. Let us further assume that taxes are currently $4.00 per square foot and the CPI is running at 2% per year. Over the past ten years property taxes have been increasing at two to three times the rate of inflation (as demonstrated in our previous articles). In this case let us assume a conservative 4% annual increase in property taxes.
The double counting comes in where the tenant is paying a 2% escalation of the base rent ($20.00 per square foot) even though $4.00 of that is real estate taxes where escalations are already being accounted for by a pro-rata share of any tax increases.
Mathematically we will demonstrate the difference between the aforementioned rent structure, a rent structure based purely on a 2% CPI increase and a structure where $16 per square foot of the rent is tied to the CPI and the $4.00 of the addition rent which reflects taxes are increased at 4% per year. Scenario One: Straight 2% CPI rent increase
Year 1 $20.00 per sf
Year 2 $20.40 per sf
Year 3 $20.81 per sf
Year 4 $21.22 per sf
Year 5 $21.65 per sf Scenario Two: $20.00 per sf rent, 2% CPI & pro rata tax increase at 4% per year 2%CPI 4% Annual Tax Increase Total Rent
Year 1 $20.00 $0 $20.00
Year 2 $20.40 $0.16 $20.56
Year 3 $20.81 $0.33 $21.14
Year 4 $21.22 $0.50 $21.72
Year 5 $21.65 $0.68 $22.33 Scenario Three: $16.00 with 2% CPI increase and $4.00 (current taxes) with pro-rata share of increases assumed at 4% per year. 2% CPI 4% Annual Tax Blended $16.00 – 2% CPI
Increase ($4.00 base) $4.00 tax – 4% increases
Year 1 $16.00 $4.00 $20.00
Year 2 $16.32 $4.16 $20.48
Year 3 $16.65 $4.33 $20.98
Year 4 $16.98 $4.50 $21.48
Year 5 $17.32 $4.68 $22.00 Summary Comparison of Three Scenarios Scenario 1 Scenario 2 Scenario 3
Straight Standard Base Rent & Blended $16 w/2% CPI &
2% CPI Pro-Rata Tax Increase $4 Per sf Pro-Rata Tax Increase
Year 1 $20.00 $20.00 $20.00
Year 2 $20.40 $20.56 $20.48
Year 3 $20.81 $21.14 $20.98
Year 4 $21.22 $21.72 $21.48
Year 5 $21.65 $22.33 $22.00
If counseling a tenant you are obviously better off with a straight CPI adjustment since property taxes usually escalate far faster than the CPI. If the landlord (not unreasonably) insists on pro-rata increases in taxes I would at least try and exclude the tax share from the CPI adjustment to prevent double counting. There is a rather obvious reasonability argument for this position. As a property owner the standard lease structure would be the preferred lease structure.
Another important consideration is whether the owner's base year of taxes is of a stabilized level or one where there was substantial temporary tax relief for high vacancy. If the property was receiving temporary tax relief in the previous year the tenant could be looking at double digit tax escalations.