Landlord Operating Escalation Clauses Bear Close Examination by Prospective Tenants
By Peter Shakalis
The various operating escalation methods that landlords utilize are not all equal. Some are substantially more costly over the term of a lease than others and in some cases, can far exceed the landlord’s annual cost increases and become a profit center.
The four basic types are: porter's wage; direct operating; fixed annual increases; and consumer price index (CPI). The porter’s wage escalation is an index based upon yearly increases in the hourly wage rate that landlords pay their building porters. This wage rate is based on a negotiated contract between the landlord and the porters’ union, the AFL-CIO Local 32BJ, which is renegotiated every three years.
A penny-for-penny porter’s wage formula will increase the tenant’s rent per square foot by one cent for every one cent increase in the building porter’s hourly wage. A penny and a half for penny formula will increase the tenant’s rent per square foot one and one-half cents for every one cent increase in the porter’s hourly wage. For example, if the wages for porters in any one year are increased by 70 cents per hour, the tenant’s annual rent will increase by $1.05 ($0.70 x 1.5) per square foot.
The direct operating escalation is the most equitable, and least expensive from the tenant perspective. The tenant pays a portion of the total yearly increases in the operating expenses of the building. These expenses include standard maintenance and repair costs, payroll, common charges for electricity and management fees. The tenant is billed based on the percentage of space it occupies in the building.
Fixed annual increases have become more common in today’s market place and are pretty straight forward and easy to compute. The base rent is increased each year at a set percentage rate, usually 2% to 3%. Landlords typically propose that these increases be compounded and cumulative yearly.
The consumer price index escalation takes the percentage increase in the CPI over and above a base year and applies it to the tenant’s base rent per square foot. If the CPI increases from 5% to 6% from one year to the next, the rent per square foot will then increase by 1%.
Each escalation has advantages and disadvantages, not all of which are monetary. Governmental agencies such as United Nations Mission offices for instance often prefer fixed annual increases which can be determined in advance for each year of the lease thereby simplifying their budgetary process. However a fixed percentage escalation can increase substantially in the latter years of a lease especially in buildings where the base rent is initially high such as class ‘A’ properties in the Midtown North business district.
The direct operating escalation is often the least costly and can represent a substantial savings compared to other types. However tenants must be careful to accept only relevant expenses. The cost of marketing vacant space and brokers’ commissions, for instance, are not a direct operating expense. Expense items such as these if included will inflate costs. The CPI escalation will vary depending on which consumer price index is used; while the hourly rate increases are greater in the porters wage formula if fringe benefits are included.
Hence it’s always important to have a professional real estate advisor negotiate for a rent escalation clause that is the best suited to the tenant’s needs, protects the tenant’s interests and is the least costly. In today’s soft real estate market landlords are more receptive to having such a discussion than they have for a long while.
Peter Shakalis is a Director at
FirstService Williams Real Estate
pshakalis@fswre.com
One item in office leases that should always be closely examined by prospective tenants are the annual increases they are charged to cover the landlord’s yearly increases in operating expenses for the building. 
