How Should Rent Escalation Clauses Address CPI?
Adam M. Levine
Rent escalation clauses are a common part of commercial property leases. One popular method for calculating the escalation amount bases the rent increases on changes in the Consumer Price Index (CPI). However, the CPI approach is not as straightforward as it might seem.
CPI in a Nutshell
The CPI is a measure of the average change over time in the prices paid by urban consumers for a “market basket” of consumer goods and services. The market basket is developed from detailed spending information provided by families and individuals. Spending items are classified into more than 200 categories arranged into eight major groups, including food and beverages, housing, apparel and transportation.
The Vagueness Risk
The CPI is published by the U.S. Bureau of Labor Statistics (BLS), which cautions that many escalation clauses tied to the CPI are vague. That is because the BLS publishes thousands of CPIs every month. To combat this risk, escalation clauses should specifically address which CPI will be used:
- The Population Group
The BLS publishes price changes for two population groups — the All Urban Consumers (CPI-U) and the narrower Urban Wage Earners and Clerical Workers (CPI-W). According to the BLS, the CPI-U is the broadest measure of consumer inflation it produces and is typically subject to less sampling error than the CPI-W.
- The Item Category
The BLS encourages users to specify a broad item category, such as the all-item index, when writing an escalation clause. Why? Because such categories are typically subject to less sampling error.
- The Geographic Area
The BLS publishes indexes for U.S. City Average (or national) level, regional level (for example, the West region) and some local metropolitan areas (for example, Atlanta). The U.S. City Average indexes have larger sample sizes than those for metropolitan areas. So, again, there will likely be less sampling error.
- Seasonal Adjustments
Some CPIs are published on a seasonally adjusted basis to eliminate the effect of price changes caused by recurring seasonal changes (for example, because of weather or holidays); these indexes are subject to annual revision. The BLS advises against using these CPIs in escalation clauses.
In addition to being clear about the CPI that will be used for rent escalation, specify in the lease the base rent amount that is subject to escalation (that is, the initial rent) and the timing and frequency of adjustments. Also, consider including a rent floor to ensure a minimum increase, regardless of the change in CPI, along with a cap that sets an upper limit for the rent increase.
For more information on rent escalation clauses, contact Adam Levine at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.