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Riding the Lease Escalator

An escalator isn't just a moving staircase. And when you're riding the commercial lease escalator, you should be going up not down. Nonetheless, some co-op owners are not even aware what a commercial escalator is — or that it can be your property's means to some welcome extra income.

James Samson, a partner in Bangser, Klein, Rocca & Blum, has found properties that have ignored or forgotten their escalators. "Every time I take on a new property with commercial space, I check out the lease's escalator," he says. "In one case, there were two stores on the ground floor which hadn't paid escalations for five years. After we calculated it, they got back about $70,000 [in additional commercial rent owed them on the lease]."

Samson says many co-ops are unaware that they have money coming to them because they have no idea of what an escalator is. If you have commercial space in your building, you should know: an escalator is the annual increase built into your commercial tenant's lease. These "escalation clauses" are very important.

"The basic point of escalations is that if you rent something in 2002 for ten years, many factors will change over time," says C. Jaye Berger, an attorney in private practice. "You know how much the rent will be but you don't know how taxes and utilities will change over that time period. So you try and establish a base year and have adjustments spring off of that. The owner has a whole variety of expenses springing from the building; it is important how you define the expenses in the lease. Sometimes people put things in that may or may not be appropriate."

There are five different types of escalator: the Tax Increase, the Porter's Wage Increase, the Consumer Price Index, the Operating Expenses Pass-Through, and the General.

The Tax Increase Escalator. This is the most straightforward escalator of all, and one that everyone must include. As taxes go up, so does the commercial tenant's rent. The base here will be the fiscal tax year, from July 1 through June 30. Each year, every property in the city is subject to increased payment of real estate taxes. The increase is caused by either a rise in the tax rate or in the assessed valuation of a building.

This type of escalator generally applies the tenant's proportionate share of the net rentable space in the building (i.e., three percent) to increases in real estate taxes occurring each year or specified period after the base year. Accordingly, if a commercial tenant occupies roughly three percent of the building's rentable area, and the taxes for any fiscal year after the initial base year established in the lease increases over the base year by $100,000, the tenant's proportionate share of that increase (i.e., three percent x $100,000 = $3,000) will be added as additional rent to his annual base rent.

"Thus," notes Edward Braverman, senior partner in Braverman & Associates, a law firm, "the commercial tenant, similar to the tenant-shareholder, will be shouldering its share of all future real estate tax increases."

The Porter's Wage Increase Escalator. This has nothing to do with whether your building has a porter or not. As with the real estate tax escalator, the lease must establish a base year — usually the year in which the tenant executes its lease. Additionally, the lease must fix and establish the total rentable square footage of the commercial premises (i.e., 4,000 square feet). Thereafter, on January 1 of each year, after the stipulated base year, the new porter wage, established by the 32BJ union contract, is measured against the base year, and the difference is applied to the commercial tenant's rentable square feet, thereby establishing an additional rent escalator for the coming year. The lease may also include a porter's fringe benefits, which are sometimes greater than the hourly rate.

The big question: why a porter? "The landlords probably picked that [contract figure] because the porters get the best increase," explains Braverman. "This type of escalation does not require the co-op to employ porters, union help, or, for that matter, any help. The use of the porter wage clause is merely a methodology by which commercial rent will be increased each year."

The Consumer Price Index Escalator. Using the consumer price index — a cost-of-living guideline — is less esoteric. Each month, the Bureau of Labor Statistics, a division of the U.S. Department of Labor, publishes the Consumer Price Index for the New York metropolitan area. "The index is designed to measure our local increased cost of living," Braverman notes.

As with the real estate tax escalator and the porter wage escalator, a base year must be established, together with a base month. Thereafter, on the month next preceding each lease year anniversary, the published Consumer Price Index is measured against the established base Consumer Price Index set forth in the commercial lease. The percentage increase thereby established is applied to the commercial tenant's base rent to thus establish the additional rent the tenant is obligated to pay for the coming lease year.

The Operating Expenses Pass-Through. Less typical in co-op leases is the operating expense pass-through, which is usually found in commercial structures. Again, a base year is established for lease purposes. In this case, the base established will be a calendar year. As with the real estate tax escalator, the tenant's percentage of rentable square footage must be established within the lease (i.e., three percent). In each calendar year after the established base calendar year, the owner must determine his increased operating expenses over the established base year. The difference, multiplied by the tenant's percentage of rentable square footage, represents the commercial tenant's additional escalation rent for the coming calendar year.

The General Escalator. Finally, the owner can simply establish an arbitrary escalation for each lease year after the first. That escalation can be represented as a percentage increase over the base rent or as a fixed dollar amount. "You can pick a number — say three percent — and increase the rent by that much every year," explains Braverman. The problem is that this does not take into account cost-of-living or inflation increases. Nonetheless, some owners choose it because of its simplicity.

Each commercial lease should contain a real estate tax escalation provision plus one other escalator. Co-ops with substantial commercial tenancies must always be aware of the problems tied in to Internal Revenue Code Section 216, which allows only 20 percent of the co-op's income to be drawn from commercial sources.

"Boards must make certain that the rent collected from a non-shareholder commercial tenant, as escalated, does not exceed 20 percent of the co-op's gross revenue for the calendar year," Braverman says. "If there is such a possibility, a process of rent abatement must be established within the commercial lease to protect the co-op's shareholders from losing their very valuable yearly tax deductions."

How can you miss an escalator? Often, it happens when a sponsor's management firm is involved. Samson says that "sponsor managing agents never remember to bill commercial tenants," usually because the sponsor has the lease on the storefronts. "Once, I had a managing agent at [a co-op] who said that the statute of limitations had run out. The escalators went back 12 years. He was wrong and we billed him."

"You have to maintain proper internal controls," adds Don Levy, director of management at Lawrence Properties. "Every year, we have our own financial control people and outside auditors and lawyers review the [commercial] leases. You don't want anything falling between the cracks. It must all be done properly. It is straightforward but something can slip by if you're not paying attention."

In the end, the idea behind escalators is equity. If the commercial leases do not contain increases, the co-op's general counsel should incorporate them for the next renewal period. Explains Braverman: "You simply want to keep the landlords' rent moving up with the economy."

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