Rent Escalations in a Sale-Leaseback: Fixed, CPI or Both?

In a sale-leaseback the first-year rent is negotiated alongside the price, and both sides study it closely. The escalation clause tends to be settled in a line of the term sheet and then compounds quietly for the rest of the lease. Because increases build on one another, a small difference in the annual rate becomes a large difference in the later years.

Here is an example that is hypothetical, for illustration only, with round numbers that are not market data. Take a starting rent of $500,000 a year on a 20-year lease.

• With a 2 percent annual increase, rent in year 20 is about $728,000, and total rent over the term is about $12.1 million.
• With a 3 percent annual increase, rent in year 20 is about $877,000, and total rent over the term is about $13.4 million.

In this illustration one percentage point adds roughly $1.3 million over the term and makes the final year's rent about 20 percent higher. A buyer will pay somewhat more today for the steeper schedule. Whether that extra price is worth the extra rent is a calculation, and it should be done before the term sheet is signed.

• Fixed annual increases. Rent rises by a stated percentage every year. Simple to budget and simple for the buyer to value.
• Fixed periodic steps. Rent is flat for several years and then steps up by a larger amount. Cash cost is lower early and jumps at each step, so check the step years against your plan.
• CPI increases. Rent rises by the change in a consumer price index over the period. Your rent follows inflation, whatever it turns out to be.
• CPI with a floor and a cap. Rent rises by the index change, but never less than the floor and never more than the cap. This is the hybrid most sellers end up discussing.
• Fixed increases with a periodic market reset. Less common in long leasebacks, because resets bring uncertainty and disputes for both sides.

Investors differ in what they prefer. Some want the certainty of a fixed schedule because it is easy to finance and to resell. Others want inflation protection. Asking bidders to price more than one structure is the only reliable way to learn what each is worth for your building.

Fixed increases put the inflation risk on the landlord. If prices rise faster than the fixed rate, your rent falls in real terms. If inflation is low, you are paying increases your own revenue may not be matching. The benefit is that every year's rent is known on the day you sign, which makes budgeting, lender covenants and a future sale of the company easier.

CPI increases put the inflation risk on you. In a period of high inflation, uncapped CPI rent can rise faster than a business is able to raise its own prices. The question to ask is how closely your revenue tracks general inflation. A company with pricing power, or with contracts that are themselves indexed, is better placed to accept a CPI clause than one selling at fixed prices under long contracts.

A floor without a cap is the structure to resist. It guarantees the landlord a minimum increase in every year while leaving you fully exposed in the bad ones. If the landlord wants a floor, the natural counter is a cap, and the cap is the number that matters most for your long-run affordability.

A CPI clause that only says rent will increase with the CPI invites a dispute, because there are many published indexes. The US Bureau of Labor Statistics, which publishes the CPI, gives guidance for escalation agreements, and it is worth following.

• Identify the index precisely: the population coverage (CPI-U or CPI-W), the area coverage and the series title, such as all items. BLS notes that CPI-U has the more comprehensive population coverage and is used in most escalation agreements other than certain wage adjustments.
• Consider the national index. BLS recommends the U.S. City Average for escalator clauses, and cautions that metropolitan area indexes often show greater volatility because of smaller samples.
• Do not use seasonally adjusted data. BLS calls it inappropriate for escalation agreements, since those figures are subject to revision.
• Specify the reference period from which changes are measured, such as a named month or an annual average, and allow for the publication lag.
• Build in a method for handling major CPI revisions or changes to the index.

BLS also states plainly that it cannot write contract language or mediate disputes between the parties. The clause has to work by its own terms, so have your attorney draft it with a worked example attached.

Ask for the escalation formula to be shown as a calculation in an exhibit, using real index values for a past period. If the two sides cannot agree on the arithmetic in the exhibit, they would not have agreed on it in year six either.

Escalations should be judged against the business, not against the first year.

1. Lay out rent for every year of the firm term under each structure being discussed. For CPI structures, run a low, a middle and a high inflation case, including the cap in every year.
2. Add the net lease costs you will also be paying, such as property taxes, insurance and maintenance, with their own growth assumptions.
3. Compare total occupancy cost with projected revenue and operating income in each year, including a downside case.
4. Check loan covenants in the later years, not only at closing.
5. Look at how renewal rent is set. If options continue the same escalations, the schedule runs longer than the firm term. If they reset to market, note the uncertainty.
6. Compare the extra purchase price each structure produces with the extra rent it costs, in present value terms, with your CFO or CPA.

One accounting note for companies reporting under US GAAP: for an operating lease, lease expense is recognized on a straight-line basis over the term. With fixed escalations, the expense on your income statement will therefore differ from the cash rent you pay in any given year. Ask your CPA how the schedule you are negotiating will be presented.

• ✓Is there a cap on every increase, and does it apply each year or only on average?
• ✓If there is a floor, is it paired with a cap?
• ✓How often does rent adjust: annually or in multi-year steps?
• ✓Is the increase compounding on the prior year's rent or calculated on the original rent?
• ✓Is the CPI series named exactly, with the reference months stated?
• ✓Is there a worked example in the lease?
• ✓What rent applies in the renewal terms, and do the same caps continue?
• ✓Has the last year's rent been compared with a realistic view of market rent for the building at that time?

We model these schedules for sellers before offers are compared, because two bids with the same price and the same first-year rent can differ widely in what they cost over the life of the lease.