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As a landlord, you have many different types of leases to choose from. There are single-net leases, triple-net leases, graduated leases, and index leases, just to name a few. With that in mind, below is your guide to the index lease. Read on to learn what this lease is and how it's used in commercial real estate, as well as the unique advantages and disadvantages of choosing this method. Armed with this knowledge, you should be able to decide if using an index lease is the right choice for you.
What is an index lease?
An index lease, also known as a variable lease, is a name for a type of clause in a lease agreement that's often used in commercial real estate. Since commercial lease agreements are often much longer than residential leases, it's common to negotiate periodic rental increases from the start. In particular, the term "index lease" refers to a method for executing that rent escalation.
An index lease is often described in contrast to a graduated lease. While the latter clause lays out graduated rent increases on a set schedule over the entire lease term, the former offers a chance at periodic increases that are tied to an index.
In this case, it might be helpful to think of a variable lease as working similarly to an adjustable-rate mortgage. If you have an adjustable-rate mortgage, for example, its variations are usually either tied to the Cost of Funds Index (COFI) or the Treasury One-Year Constant Maturity series. Meanwhile, the variations of an index lease are typically tied to the Consumer Price Index(CPI), which measures inflation.
How do index leases work?
Typically, index leases have four components: a base rent, an index of use, a rate of increase, and a growth cap. We've taken a moment to clarify each one below so you'll have a better idea of how to structure your index leases going forward.
In real estate, the term "base rent" is often used to describe the minimum amount of rent that's charged on a space with variable rent. In the case of an index lease, this is typically the same as the amount charged for rent at lease commencement. However, with other types of leases, it's possible to have a base rent be paid in addition to operating costs or, in the case of retail, a percentage of sales.
Index of use
Next, you have to specify the index you intend to use to determine the rate of increase. As stated above, many commercial real estate leases use the Consumer Price Index (CPI) in order to ensure their variable payments keep pace with inflation. However, there are many CPIs to choose from, so you have to name one as your base index. Your base index will serve as the index that the current index gets compared to at the time of each rent increase.
In order to narrow down the choices of which index to use, most lessors simply choose the CPI index that was published immediately prior to lease commencement. That said, however, you're free to choose any index you'd like for your lease.
Rent increase frequency
As the name suggests, you'll also need to specify how often your variable payments are set to increase. For context, a new CPI index is published every two months, but having six rent increases in a single calendar year would likely prove to be very confusing. Instead, it's much more common to have rent escalation occur on an annual or bi-annual basis.
Lastly, as the lessor, you probably won't want to have a growth cap in your lease agreement, but tenants frequently try to negotiate them in, so it's important to make sure you're aware of the concept. A growth cap is a ceiling for how high your rent escalation clause is allowed to go.
Calculating rent increase on an index lease: an example
The formula for calculating rent increases on an index lease is fairly simple:
(Current index value - Base index value) / Base index value
For the purposes of this example, let's say you have a base rent of $30,000 per year and the base index you chose had an index value of 201.5. At the time of your annual rent increase, the current index value is 206.7. Additionally, your growth cap is 5%.
Using the formula above and those numbers, the equation for your rent increase would be as follows:
(206.7 - 201.5) / 201.5 = 0.0258
0.0258 x 100 = 2.58%
After you've figured out the percentage of your rent increase, you would apply it to your base rent in the following manner:
$30,000 x 2.58% = $774
$30,000 + $774 = New annual lease payment
$30,774 = New annual lease payment
The pros and cons of using an index lease as a landlord
Now that you know how an index lease works, it's important to take a look at the various advantages and disadvantages of using this method for rent as a landlord. With that in mind, we've listed the biggest pros and cons out for your consideration below:
As a landlord, your biggest advantage to this method is that, since the rent increases are based on an independently published index, they're less likely to be disputed by the tenant. This is especially true if you include a sample calculation in the lease, showing how any increases will be calculated on an ongoing basis.
However, in addition, using an index to regulate the amount of your rent increases will help ensure your rents have kept a fair pace with the economy.
Unfortunately, over the last few years, this method has largely benefited tenants, especially in cases where the CPI index is used. Annual increases have been relatively small recently, which means if you haven't passed through your operating costs, there's a good chance those expenses could outpace the increase to your monthly payment, leaving you at a relative disadvantage.
Additionally, this method doesn't take into account the relative demand for or value of the property. If you're in a high-demand area, you may very well do better financially by establishing graduated increases that reflect the value of the underlying asset.
The bottom line
These days, choosing to use an index lease, especially one that's tied to the CPI index, can be a gamble. That said, it's an extremely fair method of imposing rent increases. To that end, the decision of whether or not to use an index lease as your commercial lease contract is a personal one. Use this post as a guide to help you decide whether or not using an index lease could be the right choice for you.
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