§ 19.03 Escalations

• Jurisdiction: United States
• Publication year: 2022

§ 19.03 Escalations

Escalations are a form of "additional rent."¹ Tenants are often required to pay this additional rent to the landlord over and above base rent in order to reimburse the landlord for increases in operating expenses and taxes beyond the level established in the base year calculation. Escalations may also include other increases resulting from an inflation index.

Escalation clauses are generally written in such a way that the costs to the tenant can never go down. In fact, the typical escalation clause covers only increases in costs and in the case of some leases, "escalations" are charged whether or not increases actually occur.

Despite their importance, escalation provisions traditionally have not received the full attention they deserve in commercial lease negotiations. These provisions are often filled with vague and confusing language and complex mathematical formulas, making it very difficult to determine the monthly costs and the year-end reconciliation amounts. Generally the accountants are left to handle the calculations and the various problems that arise long after the lease is signed. That is where the tenant makes his mistake. Once the lease term begins, the escalation provisions probably see as much or more activity than any other lease clause. Unlike renewals, expansions and terminations, which may take place only once during the entire lease term, the escalation billings take place annually, if not quarterly or even monthly. Escalation provisions can substantially increase the tenant's rent expense. The amounts are often compounded, resulting in rent obligations that increase quickly and in rather large increments. The escalation clause increases will vary depending on which formula is used. Some lease escalation clauses are tied to increases in real estate taxes, others to operating costs and still others are based on the Consumer Price Index, Porters' Wage, or other formulas.

Many billing disputes in commercial real estate leases arise because of vague lease language. To avoid unexpected liability and prevent unnecessary confusion and the resultant disputes, the parties should be certain to have an attorney who specializes in commercial real estate leasing review any verbiage that has ongoing economic implications.²

[1]—Net and "Not So Net" Leases

Some parts of the country have net leases, and some parts have "not so net" leases. Essentially, a net lease is one where the tenant pays a smaller base rent per square foot (presumably net of all base components), plus a percentage of operating costs and taxes for the building or complex, plus shared common area charges, such as maintenance, repairs, paving and lighting.³ The percentage of these charges to be paid by the tenant is based on the percentage of the building that the tenant occupies in relation to all of the leasable areas in the building.⁴

Under a "not so net" lease, there is generally a larger base rent figure, which includes the landlord's profit figure and other costs base components associated with the building's overall cost to run. Base rent should not include the expense of tenant operations within individual premises, however, there may be exceptions, such as rent inclusion electricity, of which the tenant should be very aware.⁵ At any rate, when all these components are bundled into the base rent figure, it is easy to lose sight of what is there and how these calculations should work. During the base year, the landlord is expected to cover all its base costs, including debt service, under its base rent figure. After that, the tenant is expected to pick up its proportionate share of subsequent increases over the base amount (whether it be a base year, stop or stipulated base amount) figure for the remainder of its lease term. The challenge to the tenant is to determine whether or not the correct numbers are working into the escalation calculations.

[2]—Cost Comparisons Between Buildings

Cost comparisons must be made between spaces available for lease in different buildings when a prospective tenant is shopping for new premises. Just as certain buildings have different usable to rentable square foot ratios, they also have different competitive advantages or disadvantages in the costs to operate them. For instance, there are many buildings in New York City that have real estate taxes in the $6.00 to $8.00 per rentable square foot range. There are also some buildings with real estate taxes of $12.00 per rentable square foot.

Likewise, some buildings are incredibly disadvantaged when it comes to utility and electrical efficiency. Their costs per rentable square foot are much higher than those buildings that are new, high tech and energy efficient. Similar discrepancies occur with respect to operating and cleaning costs for buildings that are old, versus ones that are new; or with buildings that have very sharply negotiated positions in their cleaning contracts, versus ones that have brand new maintenance and operating contracts that are advantageous to unions. These numbers have to be examined and broken down.

In addition, buildings may use different concepts of base years for calculating escalations. Some use the last year as a base year, while some buildings split years or half years. Some have fiscal years covering portions of two calendar years. Some have the current year of occupancy or the current year of the term, which can be considerably different. Some buildings pick "next year," which could turn out to be a year and some months of actual possession by the tenant. Or some buildings may use a particular base year for a given escalation and another base year for another!

In any event, care and attention should be given to these differences in order to have the definitions fully understood. The base year may be triggered by the contract portion of the lease term or it may commence upon the substantial completion of the premises when delivered by landlord to tenant. This can translate into an extremely large monetary difference and should be carefully considered and understood.

In addition, there are some very subtle, but expensive differences, between office space in buildings in which different types of uses are present. Retail space, regional malls and mixed use buildings may contain some major costly landlord "grabs." When examining a potential space to lease, these issues should be analyzed.

[3]—Taxes

[a]—Definition

In order to determine what a tenant will be paying in the way of tax escalations, the tenant must understand the definition of taxes, as well as the amount over which it will pay the increases. It is not difficult to figure out what the base year or the base amount or factor for taxes will be. These figures can be obtained from a tax assessor's office or they can be required to be verified within the lease. It is also a good idea to take the extra time to compare that figure to its component in the base rent just to see if the two figures agree. The more difficult concept, however, is calculating what taxes actually are.

Simply, taxes are a payment made by a landlord, in most regions to a governmental or quasi-governmental agency, reflecting tax rates or mill levies applied to the assessed valuation of the property as determined by the government, plus any special or benefit assessments imposed on the property. Special assessments are generally imposed either in dollar amounts, rates or dollars times square foot area or numbers of people. Special assessments are generally levied to pay for land or improvements, such as sidewalk, traffic or sewer and water service, but may also arise to benefit transportation, landmark displacement or other special governmental or human services. They are usually paid in installments by the benefited district over the useful life of the benefit.

Sales from one landlord to another during a lease term frequently triggers a reassessment of the building, which almost always results in increased property taxes. Although tenants have no say in and received no benefit from the sale of the building, they are required to pay more in property taxes when the tax reassessment indicates a greater building value. This increased cost, which is actually a cost of ownership, became the tenants' responsibility. Building owners and landlords in any markets across the country have switched from a Base Year lease to the ONNN lease, since the ONNN lease enables the great majority of ownership risk regarding operating expenses and real estate taxes to be placed on the tenants' shoulders.

[b]—Method of Calculation

The tenant must make sure that the base tax includes only that portion of the special assessments that falls within the base year period. All special assessments should be calculated upon the installment method to smooth out the impact over the term of the lease, whether or not the landlord pays them in installments. Note that landlords generally fail to include installments of special assessments in the base year. This seems to be a common practice. The affect is to shift more of the burden to the tenant by reflecting these installments as increases paid after the base year.

The other prevailing method of calculating taxes is to multiply the valuation times the rate. Here the taxing authority determines the assessed valuation of the land and the assessed valuation of the improvements upon which a mill or a tax rate levy will be imposed. Land and improvements are generally treated differently. Land may be assessed at a full value and the improvements may be phased in or partially abated. Again the tenant should examine these figures with care.

Some areas have different rates for taxes and special assessments. When calculating the taxes, especially for the base year, the tenant must make sure to understand thoroughly any reduction or limitation on the full amount of the assessed valuation of the land or the improvements by way of incentive abatements and the timing of...