Chapter 44: Rent Increases and CPI

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Chapter

44 Rent Increases and CPI After reading this chapter, you will be able to: •  understand the interrelationship between rents, inflation and appreciation; •  distinguish the effect of inflation from appreciation in any increase in a property’s rents; and •  provide for a shift of rent inflation and appreciation to the tenant in lease agreement rent provisions. appreciation-adjusted rent provision

Consumer Price Index (CPI) inflation

A long-term investment goal of an owner of rental property is to generate future annual net operating income sufficient to keep the property’s value rising in line with consumer inflation. An income property owner’s primary goal is to negotiate the best possible rental rate consistent with the highest occupancy rate attainable when entering into a lease agreement. Part of this income goal is to bargain for periodic upward rent adjustments over the life of the lease. Rent adjustments are needed to cover the loss of purchasing power in the initial rent amount brought on by annual consumer price inflation. For example, rent adjustments can be set to match the annual price inflation experienced in the region. Thus coupled with inflation, rental income will increase from year to year to maintain the original purchasing power of the property’s initial rental income over the life of the lease.

Learning Objectives

Key Terms

Coping with inflation through rent

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Consumer Price Index (CPI) The CPI measures and tracks the rate of consumer inflation. This is presented as an index of fluctuations in the general price of a wide selection of consumable products – goods and services.

appreciationadjusted rent provision A provision found in a nonresidential lease which adjusts rent to reflect an increase in the property’s rental value brought about by local demographics, not inflation.

inflation The price changes over time in consumer goods and services, quantified in the consumer price index (CPI).

For decades prior to the mid-1970s, rent adjustments in an environment of slowing rising interest rates were of little concern as inflation and appreciation rates remained low. The 1980s saw marked increases in rents and operating costs to reflect the excessive inflation of the 1970s. By the early 1990s, rents declined and appreciation rates in California reversed, stabilizing during the late-1990s. After the turn of the century, rents again began to increase, exceeding the rate of inflation as reflected in the Consumer Price Index (CPI). By 2007, rent increases began to stabilize in all areas and on all types of properties, as the real estate boom years of the mid-2000s came to a halt. Unlike rent appreciation experienced by a property due to enhanced local demographics, rent inflation is limited by any decline in the quantity of a consumer item (square footage of space) a dollar will buy (rent) due to a general price (rent) increase for the same item (comparable space). Inattentive landlords and agents occasionally fail to anticipate trends in inflation. They saddle themselves with long-term lease agreements containing rent provisions which do not adjust rent for inflation or appreciation. Since future rents are formulated in lease agreement rent provisions, the worth of the property, and thus its equity, can be calculated at any time during the term of the lease based on the capitalization rate then applied by investors. [See first tuesday Form 552 §3] Unless rent is periodically increased over the life of a long-term lease or a lease with renewal options, lease provisions setting future rents can be economically disastrous for the landlord. The periodic upward adjustments in rent amounts to be considered include: •  the rate of consumer price inflation; and •  local demographic price appreciation. A number of methods exist to keep pace over the term of a lease with consumer inflation, property rent appreciation and increases in the landlord’s operating and ownership expenses beyond the rate of inflation.

CPI covers price inflation

The best method for coping with the uncertainty of future inflation is to tie the amount due as future rents to figures published in the federal government’s CPI. The monetary policy for the dollar is set by the Federal Reserve (Fed) at 2% annually. However, inflation of greater amounts may be engineered by the Fed for a short period of time to offset declines in government spending. This Fed action will boost consumer spending, which in turn creates more jobs, boosting employment to the level sought by the Fed. Nonresidential lease agreements typically set a base monthly rent which is constant for the first year. For the following years, annual rent is adjusted by factoring in the annual change in local or regional CPI figures. For residential rent increases, most rent control communities use a form of the CPI to allow for the amount of automatic annual rent adjustments permitted

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by ordinance. The rent control formulas have worked well for landlords, especially when rents slip for reason of increased supply (construction and SFR conversion to rentals) or reduced demand (job loss during a recession). Residential leases only infrequently exceed one year. Thus, most residential lease agreements do not need to address an adjustment in monthly rents to compensate for inflation. Rent increases are negotiated at the end of the leasing period and set based on comparable market rates or, in noncompetitive environments due to restrictive zoning, as dictated by rent control. CPI figures are published monthly, bi-monthly or semi-annually by the U.S. Bureau of Labor Statistics for numerous metropolitan areas across the states. The CPI is the most widely used indicator of inflation.

CPI and its regions

The CPI measures the overall price change from month to month, up or down, for a “basket” of consumer goods and services that everyday people are believed to buy or consume. The CPI-U is based on the price of food, clothing, shelter, fuel, transportation fares, charges for doctors and dentists, drugs and other goods bought for day-to-day living. Real estate lease agreements with provisions for annual adjustments based on the rate of inflation most commonly use inflation figures from the regional CPI-U, the CPI for the area’s urban consumers. A regional CPI-U covers the buying habits of approximately 80% of the population within the designated area. The three CPI regions within California are: •  Los Angeles-Anaheim-Riverside (issued monthly); •  San Francisco-Oakland-San Jose (issued bi-monthly); and •  San Diego (issued semi-annually). If property does not fall within or near one of the regions, a landlord may also use the CPI-U for a larger geographical area such as: •  the West Region CPI-U; or •  the U.S. City Average CPI-U. The San Francisco-Oakland-San Jose CPI-U is issued bi-monthly covering consumer expenditures for two months — the month of issuance and the preceding month. The bi-monthly CPI-U for the San Francisco area is issued on even-numbered months such as February, April, June, etc. Thus, the landlord with an adjustment index tied to the January CPI-U for the San Francisco-Oakland-San Jose area uses the CPI-U which comes out in February.

Issuance date for the CPI figure

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However, the landlord located in the San Francisco-Oakland-San Jose or San Diego areas may wish to switch to a larger geographical area CPI-U index which is issued on a monthly basis. For example, the landlord can consider using the West Region CPI-U. If the landlord seeks to switch to a different index after entering into the lease agreement, the landlord and tenant must agree to the use of the new index.

Inflationary cycles and the CPI

A few basic principles of real estate economics need to be considered when applying CPI figures to periodically adjust rent upward. A rent adjustment based on consumer price inflation covers the negative effect inflation has on the purchasing power of the landlord’s rental income. With each inflation adjustment made in rent by the landlord, the nonresidential tenant in turn passes on the rent increase to consumers when pricing the goods and services they produce and sell. Also, real estate rents on the reletting of comparable properties sometimes increase in excess of consumer inflation. Any annual increase in rents paid beyond the rate of inflation is appropriately called appreciated rents. Appreciated rents directly translate on application of a capitalization rate (to the NOI) to set the property’s market value. The portion of the annual property value increase beyond the rate of inflation is the appreciated value of the property. The appreciation of rent amounts (and thus property value) is driven by population density increase in the immediate area and increased personal income beyond the rate of inflation for local residents and companies. Thus, the location of the property is “appreciated” by more families and businesses.

How CPI works

Rent cannot be increased during the term of a lease without an adjustment provision in the lease agreement. For instance, rent payments under a fixedrent lease remain constant over the life of the lease. In contrast, rent under a month-to-month rental agreement can be increased by serving a notice of change in the terms of tenancy, limited of course for most residential units located in cities burdened with rent control.1 To increase rents annually for inflation, the lease must provide a formula for calculating the rent increases. A lease provision that calls for adjustments based on the CPI-U may be worded to provide a base-to-current year increase or a year-to-year increase. The resulting rent amount is the same under either calculation.

Choosing the beginning CPI month

Regardless of the method of adjustment, base-to-current year or year-to-year, the landlord will need to select a beginning CPI-U month.

1 Calif. Civil Code §827

Chapter 44: Rent Increases and CPI

When the landlord decides to use the CPI method to raise rents, some basic guidelines should be followed: •  set, in advance, a base rent payable monthly during the first year of the lease which will be the “minimum” rent (floor) below which the rent will never fall;

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Sidebar CPI provision checklist

•  indicate the exact index to be used (e.g., the Los Angeles-Riverside-Anaheim CPI-U); •  indicate an alternative index should the one selected be discarded or altered; •  note the CPI beginning month for computing annual adjustments (often the third month before the commencement month and anniversaries of the lease); •  state the actual date for the adjusted annual graduations (e.g., September 1); and •  include provisions to cover future changes in the property’s appreciated value and operating costs (e.g., reappraisal, CAMs, etc.).whether the tenant has assigned or sublet the premises, or liened his leasehold interest

The best month to select for the CPI-U figure to be used to compute periodic adjustments is the third month preceding commencement of the lease and each anniversary of the commencement. The CPI-U figure for the third month prior to the adjustment is readily available by the time the rent adjustment needs to be calculated and the tenant is advised of the adjusted amount of rent due. Otherwise, if the CPI-U figure chosen is for the month in which the rent will be adjusted, the landlord will need to estimate the CPI-U figure at the time of the adjustment. The actual CPI-U figure for the anniversary month to make the adjustment called for in the lease will not be available for another two months. Computation of the annual adjusted rent is either by base year CPI-U-to-current year CPI-U, or by year-to-year CPI-U. [See Sidebar, “CPI provision checklist.”] Consider a lease rent provision which provides for a base-to-current year adjustment. [See Figure 1] The lease commenced on January 1, 2005. The base rent is $5,000 per month for the first year. The rent is to be adjusted each January and the CPI-U index to be used is the Los Angeles-Anaheim-Riverside index. The CPI-U figure for the October prior to January, the month of adjustment, is selected as the base month figure for rent adjustments. The CPI-U figure for the third month preceding commencement will be available to calculate the amount of the adjusted rent before the January rent is due. The CPI-U for October 2004 is 196.3, the base month figure. In January 2006, the first rent adjustment takes place. The CPI-U for October 2005 is 206.9. To calculate the base-to-current year adjustment, the formula is — the current CPI-U divided by the base CPI-U multiplied by the base rent: (current CPI-U ÷ base CPI-U) × base rent.

Base-tocurrent year adjustment

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Figure 1 Excerpt from Form 552 Nonresidential Lease Agreement For the second year (2006) of the lease, the rent is $5,270 — (206.9 ÷ 196.3) × $5,000. For 2007, the third year of the lease, the October 2006 CPI-U is 211.4. Thus, in January 2007, the rent adjusts to $5,385 — (211.4 ÷ 196.3) × $5,000.

Year-to-year adjustment

Under year-to-year rent adjustment provisions, the prior year’s rent, not the base year’s rent, is used to set the adjusted rent. The base year’s CPI-U is not used to make the future adjustment. Thus, the year-to-year adjustment formula is the current CPI-U divided by last year’s CPI-U, multiplied by the current rent: (current CPI-U ÷ last year’s CPI-U) × current rent.

CPI advantages

Three advantages are provided by using the CPI as a basis for rent adjustments. The first and most obvious advantage is that the CPI is universally known and easily understood. Little room exists for the parties to disagree over the amount of a rent increase if it is tied to a government published index. Second, the CPI is inexpensive to administer. It only takes a few minutes and a calculator to adjust the rents each year. Third, the CPI is a widely published and recognized index.

CPI limitations on yield

Despite the advantages, the CPI has its limitations. The CPI bears little to no relationship to changes in the property’s actual rental value. The CPI only measures changes in the purchasing power of the dollar as reflected in consumer prices which includes residential rents (not prices). Rents are forged by a combination of local demographics (density and income), government programs and supply of available units or space. However, nonresidential leasing arrangements must be worded to capture these conditions over a longer period of time, a situation not present in residential leases. Consider that each parcel of real estate is a unique asset. The location of a property makes the primary difference since no two locations have exactly the same desirability factors affecting value.

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An individual property experiences an increase or decrease in rental value for a number of reasons other than inflation, including: •  traffic counts and access to the property; •  tenant demand and changes in the size and wealth of the surrounding population; •  operating expenses; •  mortgage interest rates and investor capitalization rates; and •  construction starts. The regional CPI as a factor for diminished purchasing power of a dollar takes none of these local economic factors into consideration (other than to the extent they are reflected in residential rents which is just one aspect of CPI). Interest rates charged to home buyers are indirectly included in the CPI by using implicit rent as the cost of possession. The effect of interest rates on real estate values is not included since debt is capital and real estate is a capital asset the value of which is not itself consumed. Cyclically, and in the short term, asset values run opposite to the direction interest rates move. When interest rates go down, values of real estate (and other assets) accelerate even as rents remain the same, and vice versa. Also, the CPI does not mirror actual variations in the landlord’s operating costs. An owner who does nothing to maintain their property, thereby reducing operating expenses, can, in a high demand location, enjoy rent increases due to the public’s appreciation for the property’s desirable location. Astute tenants insist on an annual cap when rent increases are linked to CPI. For example, if the rise in the CPI figure is greater than 4% in any year, a 4% cap would limit the increase despite a greater increase in the CPI. The key is to analyze where inflation is headed. If inflation is expected to rise in the future, then the CPI will initially benefit the landlord. Conversely, when inflation has topped off and is dropping, the CPI will appear to benefit the tenant. Also, a shock to local rental market conditions, such as overbuilding or the exodus of a rental age or business group, can completely eliminate inflationary and interest rate effects on rent. Again, the CPI is a good method for controlling the inflationary reduction of the purchasing power of the U.S. dollar received in payment of rent. But inflation’s effect on rent amounts covered by the annual CPI adjustments is not the only concern of the property manager. Property appreciation and increased operating costs need to be managed to increase, or at worst maintain, the property’s NOI, and thus the property’s value. It is advisable to add a reappraisal and rent adjustment provision to longterm leases rather than rely solely on the CPI. However, reappraisal methods

Alternatives to the CPI

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are costly, time consuming and not always without argument. Managers may feel it is too involved to reappraise the property every few years to set the new rents. Also, appraisal provisions usually call for a reappraisal and recast of the rent schedule at three-to-five year intervals or on exercise of renewal options when the rental rates are set to adjust to market rents. [See first tuesday Form 552 §3.3]

Upward shifts in rent

Some leases allow the landlord to use their judgment to set the rent for the adjustment, which must be exercised reasonably. A provision for the periodic adjustment of rents to current rental rates is good insurance for a landlord to capture any upward shifts in rents paid in the local rental market beyond those brought about by inflation. This periodic recast of the rent payment is economically comparable to the rollover feature some lenders include in their three-or five-year adjustable rate or rollover loans. In addition to base rents, CPI adjustments and rollover features, percentage rent provisions also capture the increase in rents due to appreciation based on a change in local demographics. [See Chapter 45] If the property is in an outstanding location, or promoted by the landlord to attract an ever greater number of consumers which results in an increase in the tenant’s gross income, the landlord needs to consider negotiating a percentage rent adjustment provision to better “cash in” on the draw of the property’s location.

Operating expenses

Many nonresidential leases include an additional rent provision to reimburse the landlord for their operating expenses. Rent can be adjusted to include the operating expenses and any taxes and assessments incurred by the property, called common area maintenance (CAM) expenses. [See first tuesday Form 552-3] CAM provisions obligate the tenant to pay a pro rata share of the costs to maintain the common areas of the property including: •  utilities (water, gas, heat, etc.); •  air conditioning and venting; •  sewage; •  garbage; •  janitorial services; •  landscaping; •  security; •  insurance premiums;

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•  management fees; and •  real estate taxes. The more operating costs passed on to the tenant, the closer the lease comes to a full net lease.

To increase rents annually for inflation, the lease must provide a formula for calculating rent increases.

Chapter 44 Summary

A provision for the periodic adjustment of rents to current rental rates is prudent insurance for a landlord to capture upward shifts in rents paid in the local rental market beyond those brought about by inflation. The best method for coping with the uncertainty of future inflation is to tie the amount due as future rents to figures published in the federal government’s consumer price index (CPI). CPI figures are published monthly, bi-monthly or semi-annually by the U.S. Bureau of Labor Statistics for numerous metropolitan areas across the states. The CPI is the most widely used indicator of inflation. appreciation-adjusted rent provision ................................... pg. 414 Consumer Price Index (CPI) .................................................... pg. 414 inflation ........................................................................................ pg. 414

Quiz 11 Covering Chapters 41-45 is located on page 587.

Chapter 44 Key Terms