The 5 Things Every Real Estate Lease Should Have

Whether you rent office space, a warehouse, or a retail store, your lease probably has language that ties rent you pay to the Consumer Price Index. The idea is meant to benefit only the landlord, because the rental income retains its purchasing power. The problem is that there is more than one Consumer Price Index and there are different ways to calculate each, so make sure your lease agreement contains language that is very specific. One example of lease language referencing the CPI is:

The rental under this lease shall be four ($4.00) dollars per square foot for the first twelve (12) months, with annual adjustments tied to the Consumer Price Index (published by the Bureau of Labor Statistics, All Urban Consumers, Current Series, Index) for the previous calendar year period.

 

Five Things Every Lease Should Make Clear

  1. It Is Clear Where The CPI Is Published-If rent is tied to an index, what index is used and where can you find it? The above lease language spells out that the rent is adjusted by the Consumer Price Index, and tells the information is published by the Bureau of Labor Statistics, which is found easily online.
  2. It Is Clear What Type of Consumer Price Index Is Used-There are 4 methods used to calculate the Consumer Price Index:CPI Databases
    1. All Urban Consumers (Current)-Consists of all urban households in Metropolitan Statistical Areas (MSAs) and in urban places of 2,500 inhabitants or more. Nonfarm consumers living in rural areas within MSAs are included, but the index excludes rural nonmetropolitan consumers and the military and the institutional population.
    2. Urban Wage Earners and Clerical Workers (Current)-Consists of consumer units with clerical workers, sales workers, protective and other service workers, laborers, or construction workers. More than one-half of the consumer units income has to be earned from these occupations, and at least one of the members must be employed for 37 weeks or more in an eligible occupation.
    3. All Urban Consumers (Chained)-The urban consumer population is deemed by many as a better representative measure of the general public because 90% of the country’s population lives in urban areas. Using chained CPI means the rate at which Social Security benefits tick up would be slower, because it reflects substitutions consumers would make in response to rising prices of certain items. Therein lies the “chained” part of the name. The metric utilizes a basket of goods and services that are measured changes from month to month; much like a daisy chain. If the cost of a certain form of transportation goes up, for example, people might switch to another kind. This kind of “substitution” is part of what is factored into chained CPI.
    4. Average Price Data– average price dataCalculated for specific items such as, household fuel, motor fuel, and food items from prices collected for the Consumer Price Index (CPI).  Average prices are best used to measure the price level in a particular month, not to measure price change over time.
  3. It Is Clear How The Adjustment Is Applied-The CPI adjustment can applied to a lease payment monthly, quarterly, or annually, but be clear about what period of CPI is used. It is best that landlord and tenant agree the CPI is for the previous 12 months and applied to the last rent payment.
  4. It Is Clear Whether The CPI Is Adjusted For Seasonal Changes-The CPI can be adjusted for changing climatic conditions, production cycles, model changeovers, holidays, and holiday sales which can cause variation in prices. For example, oranges can be purchased year-round, but prices are significantly higher in the summer months when the major sources of supply are between harvests.
  5. It Is Clear Whether The CPI Is National or Local-The CPI publishes unadjusted price indexes at the national, metropolitan area, and regional levels. So you could drill down and calculate your CPI based on your city’s MSA. This would be more meaningful if your economy is an outlier, such as Houston, Detroit, or New Orleans.

How Is The CPI Calculated

In calculating the CPI, the urban portion of the United States is divided into 38 geographic areas called index areas, and the set of all goods and services purchased by consumers is divided into 211 categories called item strata. This results in 8,018 (38 × 211) combinations.

The CPI is calculated in two stages. The first stage is the calculation of basic indexes, which show the average price change of the items within each of the 8,018 CPI item-area combinations. At the second stage, aggregate indexes are produced by averaging across subsets of the 8,018 CPI item–area combinations.

Percent changes for periods other than 1 year often are expressed as annualized percentages. Annualized percent changes indicate what the change would be if the CPI continued to change at the same rate each month over a 12-month period. These are calculated using the standard formula for compound growth:

CPI formula

What Is Included In The CPI

The CPI represents all goods and services purchased for consumption by the reference population with all expenditure items divided into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

  1. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
  2. HOUSING (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
  3. APPAREL (men’s shirts and sweaters, women’s dresses, jewelry)
  4. TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
  5. MEDICAL CARE (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
  6. RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
  7. EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
  8. OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

What Does Yesterday’s Release Of The CPI Tell Us

The Bureau of Labor Statistics, under the Department of Labor, released the latest Consumer Price Index numbers yesterday, using the All Urban Consumers Index which increased 0.2 percent  in August, but this was for only one month and it was not seasonally adjusted. The seasonally adjusted number increased 0.3 percent, the largest increase in 6 months, due to increases for shelter and medical care.

Some August prices increased while others decreased, which is why the CPI can be misleading. The indexes increased for motor vehicle insurance, apparel, communication, and tobacco; however, the indexes decreased for used cars and trucks, household furnishings and operations, recreation, and airline fares.

These numbers are only for the month of August, and leases should use the annual number. The all items index rose 1.1 percent for the 12 months ending August. The index for all items less food and energy rose 2.3 percent for the 12 months ending August. The food index was unchanged over the last year while the energy index declined 9.2 percent.

 

CPI Table

How Much Difference Can 1 Percent Make

Inflation is not what it used to be. In the 1980’s the CPI approached 20% and the greatest economist alive said it was going to 25%. It went to 2%. Our economy today is driven by a different wage/price spiral and low inflation helps borrowers and hurts landlords and savers. Building in a CPI adjustment can still make a difference in a long term lease, as shown in the table below which compares a 1 percent CPI to a 2 percent CPI adjustment over a 25 year time frame. A 1 percent incremental rate increase annually results in $378,000 additional income over the 25 year span, and assuming a 10 percent Capitalization Rate, increases the market value of the property $338,000, or 33%.

CPI Scenario

Summary

In leasing any type of property, whether you are the landlord or the tenant, make sure your lease is clear about what the rent is, and what inflation adjustments apply to the rent. Any lease document can be revised, even though some parties say they use a standard lease. There is no such thing. A lease is an agreement between two parties, and you should revise it to include language that works for you. As always, consult an expert.


Free Lease Consultation: If you have questions about a lease document, Louisiana Commercial Realty offers a free lease review, which includes an analysis of nearby rental market prices.

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