CPI Rent Escalation
A form of contractual rent increase determined by changes in the Consumer Price Index, a common index used to measure inflation in the United States. Most long-term leases in commercial real estate include periodic rent increases. These rent increases are included in leases, in part, to ensure that the value of the lease does not diminish over time due to inflation.
Generally, the amount or percentage of the increase is pre-defined (e.g. $2/SF/YR, 2.5%/year, 10% every five years, etc). However, in some cases the landlord and tenant agree to use the change in the Consumer Price Index to determine the periodic increase.
So, if for instance the lease calls for annual CPI rent escalations, the rent due to the landlord will increase each year by the amount that CPI increases each year.
Note that while the Consumer Price Index is administered by the U.S. Bureau of Labor Statistics and in real estate is most commonly seen in US-based leases, it is not uncommon to also see CPI rent escalations in non-US leases when those leases are denominated in US Dollars (e.g. USD-denominated Industrial Leases in Mexico).
Putting ‘CPI Rent Escalation’ in Context
Scenario:
Heartland Retail Partners, a real estate investment firm with a focus on core-plus retail assets, recently acquired Gateway Plaza Mall, a 750,000 square foot regional shopping center located in Kansas City, Missouri. The mall is anchored by several national retailers and includes a mix of fashion, dining, and entertainment tenants. Heartland Retail Partners’ investment strategy is to enhance the mall’s tenant mix and improve its operational performance over time.
CPI Rent Escalation in Practice:
As part of the lease negotiations with tenants, Heartland Retail Partners implemented CPI rent escalation clauses in the majority of the mall’s long-term leases. These clauses were designed to ensure that the rental income from tenants keeps pace with inflation, thus preserving the purchasing power of the lease income and protecting the asset’s cash flow.
For example, one of the mall’s tenants, a popular clothing retailer occupying a 10,000 square foot space, agreed to a 10-year lease in 2023 with an initial rent of $25 per square foot per year. The lease includes an annual CPI rent escalation clause tied to the Consumer Price Index for All Urban Consumers (CPI-U) for the Midwest region, published by the U.S. Bureau of Labor Statistics.
Example Calculation:
Assume that the CPI-U for the Midwest increased by 2.5% from 2023 to 2024. The rent for the clothing retailer in 2024 would be calculated as follows:
New Rent per SF = Initial Rent per SF × (1 + CPI Increase)
New Rent per SF = $25 × (1 + 0.025) = $25.63
The total annual rent for the space in 2024 would be:
Total Annual Rent = New Rent per SF × Leased Square Footage
Total Annual Rent = $25.63 × 10,000 = $256,300
Therefore, in 2024, the clothing retailer would pay $256,300 annually, up from $250,000 in 2023.
Impact on the Investment:
For Heartland Retail Partners, incorporating CPI rent escalation clauses in the leases at Gateway Plaza Mall helps to protect the property’s net operating income (NOI) from the eroding effects of inflation. This is particularly important in a core-plus investment, where maintaining steady income growth is key to achieving the desired return on investment.
In an inflationary environment, the use of CPI rent escalations can also be advantageous when managing operating expenses, many of which are subject to inflationary pressures themselves. By tying rent increases to CPI, Heartland Retail Partners ensures that rent revenues rise in tandem with the costs of operating the mall, such as utilities, maintenance, and security.
Furthermore, this strategy helps Heartland Retail Partners fulfill its fiduciary duty to investors by ensuring that the property’s income stream remains resilient against inflation, thus enhancing the overall value of Gateway Plaza Mall over the holding period.
This scenario demonstrates how CPI rent escalation clauses can be an effective tool in retail leasing, providing a balanced approach that benefits both the landlord and tenants by ensuring rent adjustments reflect real economic conditions.
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