Unless commercial property owners switch from fixed indexing to variable indexing for rent increases, cash flow will be negatively affected by inflation.
Commercial real estate leases typically include fixed annual rental rate increases, both on short-term and long-term agreements. These rate increases, which have often been in the range of 3-4% per annum in recent years, allow property owners and managers to increase both the value of an asset and the value of cash flows. related to this asset.
But this fixed rate indexing approach only works for landlords if increases in rental rates keep pace with inflation. And if inflation continues to follow the trend seen in recent months, the “real return” on properties will erode if landlords do not manage rent increases to keep pace with inflation.
To solve this problem, landlords should consider using another type of clause in their rental contracts – the consumer price index (CPI) – or rent indexation clauses.
When is an indexed index clause a good idea?
In triple net single tenant investments, there has been a shift over the past two decades towards a fixed base percentage rent increase. After all, fixed rent increases make it easier to underwrite and forecast returns because the rate increase is a predetermined constant. On the other hand, the fact of basing the increases on the CPI, or on certain indexed rates, entails readjustments and regularizations of rents each year.
The flip side, however, is that fixed rate increases don’t work as well in an inflationary environment, as we are apparently heading. It would therefore be wise to consider using variable indexed rental rate adjustments linked to a benchmark interest rate (such as the CPI) or any index that adjusts for the rate of inflation.
What types of leases are particularly affected?
Inflation can be expected to impact many segments of the commercial real estate market, but long-term net leases are of particular concern.
In short-term situations, a cash flow problem can often be corrected with renewals or new leases. But in long-term leases, like those for 10, 15 or 20 years, it is necessary to include language on indexation clauses that will allow variable rate increases over the term of the lease.
Particularly relevant to this problem, long-term net leases are popular for large, capital-intensive assets such as data centers, surgery centers, radiation oncology centers, and other types of medical practices. These real estate assets, with their long-term leases, are often sold as investments, with terms of more than 10 years and several predetermined rent increases.
What does this mean for investment properties?
Even in this tight supply market, there has been talk in the market of investors making deals for assets that have fixed rate increases in long-term leases, even when the deals involve sound credit and well structured leases. This should be of concern to both homeowners and investors.
This is an important topic to discuss now, because if inflation becomes a continuing trend, or “non-transient”, it will affect the way investors perceive and evaluate proposed purchases. We can see lenders dictating a change in the way landlords design their rent increases, and at least expect to see more buyouts as policyholders consider “real return” or the impact of the rent rate. prevailing inflation on the return on investment of the asset.
What Should Property Owners and Managers Do?
The market is still fluid, but we can expect cash flows on long-term fixed leases to be negatively affected by inflation unless the owner can switch from fixed to variable indexation to rent increases. And if owners don’t act quickly, they could see the asset’s value drop to investors.
With all indicators pointing to continued inflation, it’s time to consider these changes now.
Structuring a lease with increases based on CPI or some other index requires meaningful conversations between tenant and landlord, to make sure everyone is aware of the impact of those increases on the return on the owner’s expected investment and the tenant’s forecast for the future.
Since the escalation rate is variable and can fluctuate from month to month, it is important to work with the landlord’s lawyer to define the appropriate language so that the landlord and tenant can clearly determine the best one. type of rate increase. There should also be references to the index used and how the pricing formula will be taken into account, as well as a timeline indicating when the rate increases will take effect.