What is an index lease?
An index lease is a type of clause in a lease agreement that is often used in commercial real estate. Index leases, unlike traditional leases or graduated leases, don’t have a set predefined increase over time .
The term “index lease” can be explained in the same way as an adjustable-rate mortgage. Just like an adjustable-rate mortgage there can be variations in index leases. These variations usually use the consumer price index to account for the cost of inflation.
How do index leases work?
Four pillars make up index leases: base rent, common lease indexes, a rate of increase, and a growth cap. They all serve a unique function to help create an index lease. Base rent is the minimum amount the lessor will charge for rent. An index of use is a metric that changes at the same rate as the index. A rate of increase is a constant amount that will be added to the base rent. A growth cap is how much the base rent can increase each year.
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 or the previous term. 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.
Common Lease Indexes
Prime used as an index is the interest rate that banks will charge their clients with the best credit ratings.
CPI stands for consumer price index. CPI shows tenants how much their rent will increase annually. Rent tends to increase annually as property prices also increase. Leases should indicate what the annual CPI index is being used and the adjustments made to the rent amount. CPI can be seasonally adjusted and adjusted by region. It is important to know which region and indexes are being used.
The producer price index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indexes that calculates and represents the average movement in selling prices from domestic production over time.
LIBOR or London Interbank Offered Rate is a globally accepted benchmark rate. LIBOR is used by major global banks to lend to each other in the international interbank market for short-term loans. This index is being deprecated as more institutions move to other indexes.
Rent increase frequency:
Rent increase frequency refers to how often your variable payments are set to increase. The most common types of rent escalations occur on an annual or biannual basis.
Landlords typically will not want to have a growth cap in their lease agreement. However, tenants will try to negotiate for a growth cap. Growth caps prevent the cost of rent being raised by an unlimited amount. This will protect the tenant from having to pay an outrageous amount that they might be unable to afford. There are several ways to limit the exposure to increases, such as year over year increases or year over base. Whereas year over year limits the increase to a set amount over the previous year, year over base defines a cap related to the first year of the lease.
Calculating rent increase on an index lease: an example
When calculating an index lease that in itself is not a percentage such as “Prime”, the formula is (Current index value – Base index value) / Base index value. You’ll want to make sure to use this formula as a tenant or a landlord so you know how much rent to pay or collect. Let’s see how we use this equation with our own numbers.
Let’s say the current index value is 206.7 and the base index value is 201.5.
The equation for the rent increase would be as follows: (206.7 – 201.5) / 201.5 = 0.0258
After calculating the percentage of the rent increase, add it to the base rent in the following manner: $30,000 x 2.58% = $774
The pros and cons of using an index lease as a landlord
Using an index lease to determine the monthly rent allows it to be based on an independently published index and is less likely to be disputed by tenants. Due to the fact that everything is detailed in the published index for the tenant to review before signing the lease, they should have a very good understanding of the lease agreement. Ultimately, this will result in less problems for the tenant and the landlord.
It’s important to look at the whole picture when using an index lease. Increases should be based on the cost of inflation to the landlord’s expenses. If the landlord wants to continue making a profit they must understand how their expenses are going to change based on inflation. The CPI index is not always accurate. When creating the lease the landlord might set the CPI, however if the cost of living increases more than expected, then the CPI will not be accurate, resulting in a loss for the landlord.