Annual rent increases are a commercial real estate investors best friend. Commercial real estate has long been lauded not only for its strong investment performance but for its hedge against inflation. What other asset can you leverage with fixed rate financing and then have the income increase with time?
When looking at the leases that comprise that income landlords and investors have historically favored fixed rate rental increases. I am defining a fixed rate rental increase as an increase in the rental amount based on a fixed percentage or dollar amount. For example, the rent could increase by 2% annually or 10% every 5 years. Sometimes it is described as a fixed dollar amount as in $500 per year. This rental increase method has been preferred because it is easily definable, calculable, and it simplifies budgeting.
Currently investors face a dilemma when looking at new leases or analyzing commercial real estate investments. There are many economic experts in the country concerned about inflation in coming years. This creates a situation where a fixed rate increase may not keep up with the time value of money creating a situation where the value of the lease actually decreases year to year. Many investors are turning towards rental increases based on inflationary indexes such as the consumer price index (CPI) and other methods. The challenge with this method is that there are many ways to calculate this index and it is difficult to track. It requires an annual discussion with the tenant to determine what rent will be going forward and is sometimes the source of contention and bad feelings if there is a disagreement on how the escalation is being applied.
The flip-side of this coin is that tenants are looking at these same considerations. They don’t want the risk of inflation passed to them either. Strong credit tenants are often times even able to negotiate flat lease rates during their lease terms. In recent years tenants such as Family Dollar and Walgreen’s have become darlings for commercial real estate investors and 1031 exchange buyers. For example, Family Dollar will typically sign 10 year leases during their initial term and will typically require a flat lease rate during that term. Similarly Walgreen’s has been able to obtain leases as long as 25 years with no annual increases. Many investors have concluded that they are willing to take that risk in exchange for the strength of the tenant. What will the value of those rental dollars be at the end of those leases? It is a crystal ball question but if we do experience high degrees of inflation those leases could become problematic.
Regardless of how each individual commercial real estate investors views the threat of an inflationary market, each should be considering this aspect of the investment both in lease negotiations and new property acquisitions.