The Power of the CPI
This is the biggest mistake your attorney could make when reviewing your lease.
Whether you rent space in Class A office towers, a warehouse to store inventory or just enough room for your coffee shop, your lease probably includes unfavorable terms your attorney overlooked.
Even small mistakes can be very costly unless your lease language is clear on every detail, and the most common mistake is simply overlooked by attorneys reviewing your lease.
Most Leases Include Price Increases Tied To The Consumer Price Index (CPI) The history of linking rent payments to inflation became strategic in the days of high inflation in the 1970s, when the OPEC oil embargo caused oil prices to skyrocket. When higher oil prices later combined with the wage-price spiral, there was an overnight jump in inflation from 3.2 percent in 1972 to 11 percent in 1974. This caused landlords to realize that rental income did not retain its purchasing power — the economic theory that a dollar in the future should buy the same amount of goods as it does today.
Today, it is common practice for leases to include CPI language to protect landlords, but the problem is that there is more than one consumer price index and there are different ways to calculate each. Most legal advisors are not aware of how significantly this language can affect your pocketbook.
Make Your Lease Clear What CPI Is Used To Adjust Rent Here is an example of the lease language used by $2.6 billion market cap Regus PLC in 3,000 locations:
8.7- If this agreement is for a term of more than 12 months, the provider will increase the monthly office fee on each anniversary of the start date. This increase will be by the local Consumer Price Index or such other broadly equivalent index where a consumer price index is not available locally.
This Regus lease language leaves lots of room for dispute, because the consumer price index has four ways of being calculated. The CPI index is produced by the Bureau of Labor Statistics, under the United States Department of Labor.
The four types of consumer price indices are:
All Urban Consumers (Current) Consists of all urban households in Metropolitan Statistical Areas (MSAs) and in urban places of 2,500 inhabitants or more. Non-farm consumers living in rural areas within MSAs are included, but the index excludes rural nonmetropolitan consumers and the military and the institutional population.
Urban Wage Earners and Clerical Workers (Current) Consists of clerical workers, sales workers, protective and other service workers, laborers, or construction workers. More than one-half of the consumer 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.
All Urban Consumers (Chained) The urban consumer population is deemed by many as a better representative measure of the general public because 90 percent of the country’s population lives in urban areas. It 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, people might switch to another kind and this kind of “substitution” is part of what is factored into chained CPI.
Average Price Data Calculated for specific items such as, household fuel, motor fuel and food items. Average prices are best used to measure the price level in a particular month, not to measure price change over time.
The most common CPI Index is the All Urban Consumers Index, but it has two methods used to calculate the numbers: One uses the base period of 1982-1984 as 100, and the other method uses a base period of 1967 as 100. Most leases make the mistake of not being clear about which index is used. In addition, the data can be seasonally adjusted or not seasonally adjusted (which is released faster).
You can design your table data at the Bureau of Labor website, and if your property is in New Orleans, you can even produce a local consumer price Index.
Make Your Lease Clear How The CPI Is Calculated Here is lease language for a medical property that makes the CPI data source very clear:
Consumer Price Index: It is further understood and agreed by and between lessor and lessee that, commencing with the first day of the second year of lease, the monthly rental as set forth above will be adjusted upwards at the beginning of the second lease year, and every year thereafter until expiration or termination of the lease using the all urban consumers (CPl-U) United States City Average, All Items, (1967=100) published by the Bureau of Labor Statistics, United States Department of Labor (referred to as “Consumer Price Index”).
How CPI Adjustments Affect Property Value Our economy today is driven by a different wage/price spiral which causes low inflation. This helps borrowers but hurts landlords and savers. One strategy utilized is to build in a fixed-rate adjustment in addition to a CPI adjustment because the challenge for landlords is that the CPI since 2012 has averaged 1.3 percent, which doesn’t keep up with 3 percent average annual medical care increases.
One strategy that benefits landlords is to include lease language stating the rent adjusts based on the CPI or a fixed rate, whichever is higher. Comparing an average 1.3 percent annual CPI to a fixed rate of 3 percent with rent income of $100,000 would increase rent by $95,399 in year 30, which at an 8 percent cap rate adds $1,192,486 more market value to the property.
Remember, simply overlooking lease language can be costly.
Robert Hand, CCIM, SIOR, MBA is president of Louisiana Commercial Realty, a top-rated commercial real estate firm with offices in New Orleans and Hattiesburg, Miss.