Negotiating Leases For Commercial Real Estate In A Time Of High Inflation
In normal times, negotiating a commercial real estate lease is a substantial undertaking. Commercial leases carry long terms (often ten years with renewal periods) do not have early termination provisions, and some if not all of the costs associated with operating the property are passed along by the landlord to the tenant. The COVID-19 Pandemic severely impacted commercial real estate, leaving vacancies, defaulting tenants and also tenants not paying for a time after invoking force majeure clauses. As the economy reopened and businesses moved back to their commercial space or entered into leases for new commercial space, the high inflation of the last several months makes the negotiation of a new lease (or the renegotiation of an existing lease where this is possible) an even higher stakes undertaking.
Commercial leases for real estate are often triple net leases, meaning that the cost for real estate taxes, insurance and operating expenses are passed on to the tenant. Typically, there may be an escalator for base rent of a fixed percentage from year to year; and also a similar escalator or cap with regard to operating expenses for the property. In an era of low inflation, these escalators and/or caps would usually be a low fixed rate typically 2 to 3 percent for an escalator for base rent and a cap on operating expenses of 5 to 6 percent. Landlords and tenants could link the escalator/cap, to the consumer price index to cushion against fluctuations in inflation. Doing so, however, eliminates the certainty of having a fixed escalator/cap, and has the potential to create substantial uncertainty for the landlord and tenant with regard to their future expenses. In an era of low inflation, a fixed escalator/cap was commonplace.
The current high rates of inflation create a dilemma for both landlords and tenants. If inflation remains high, an escalator/cap negotiated at too low a level would have an adverse financial impact to the landlord; while an escalator/cap negotiated too high could have a similar adverse financial impact on the tenant. While the uncertainty of the current inflationary environment leads to difficult choices with regard to the negotiation of escalators/caps, other issues regarding the lease and expenses are important to negotiate as well. These include what items would be included in operating expenses, how normal repairs as opposed to replacements are handled, and also whether capital expenditures are part of operating expenses or something reserved for landlord. Both landlords and tenants need to be extra careful in the current environment in negotiating both the business terms and legal terms of a lease, and employ experienced legal counsel in guiding them through this process.