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As a commercial tenant, you may have a clause in your lease that relates to CPI. Understanding what this means is important, so I’ve created the following guide to help teach people about CPI in Commercial Leases.
CPI stands for the Consumer Price Index. It’s a measure of how prices change over time, and is most commonly used in commercial leases to measure rental increases. CPI is the most common metric for calculating inflation, which shows how the purchasing power that one dollar has from year to year.
In the following guide, we’re going to go into more detail about what CPI does and how it’s used in general. Then, we’re going to talk about CPI and how it relates to commercial real estate: how it’s used, what its pros and cons are, and what some alternative methods are for determining rental increases.
As I said above, CPI is an abbreviation for the Consumer Price Index. The consumer price index is a metric that judges how the price of commonly purchased goods and services will change over time.
The consumer price index is usually calculated by a country’s central bank. To do so, the bank first determines a ‘basket’ of goods that they are going to measure. These goods are meant to represent what an ‘average’ consumer would buy in a year: items such as food, housing, recreation, transportation, etc.
The bank then measures the price of these items for a given year and judges it against the prices of those same items in some ‘base’ year.
By doing this, banks can see how much the cost of an ‘average’ consumer’s goods have changed over a period of time. In this way, CPI can act as a proxy for inflation. Inflation is the increase in the price of goods and services over time.
Measuring inflation allows central banks to keep track of economic trends and make decision concerning monetary and fiscal policy. Banks calculate the consumer price index so they have some basis upon which to make these decisions.
Banks can also calculate CPI for specific geographical areas to allow for greater specificity. If the economy is booming in one part of the country but shrinking in another, prices may be behaving differently; by narrowing down the geographical region for which they calculate CPI, banks can better understand how it will impact individual consumers.
In summary: CPI is a measurement of how prices change over time, calculated by tracking how the price of common household goods differ from year to year.
Now that we’re familiar with what the consumer price index is, let’s look at how it gets used in commercial real estate, and what you need to know about it as a tenant.
The most common utilization of CPI in commercial real estate is to use it to calculate rental increases from year to year. Instead of picking a fixed dollar or percentage increase, your rent will instead increase by the same amount as the consumer price index.
To help illustrate this, let’s use an example:
By using calculations like the one above, your rent will move in conjunction with CPI.
Rent doesn’t always have to move by the exact same amount as CPI, either.
Sometimes there will be set floors or ceilings built into the increase.
Say, for example, you wanted to make sure that you weren’t going to pay too much: you might agree that the rent will increase by the same amount as CPI to a maximum of a 6% increase per year.
Similarly, landlords can protect their interest by installing ‘floors’, so that the rent will increase either by a minimum of a given percentage (e.g. 2%), or by the amount of that CPI changes.
The theory of using CPI to calculate rental increases relates back to the idea of inflation being the measure of how much a single dollar can buy in terms of goods and services. Remember, your landlord is also a consumer. The money you give them in rent is then used for them to buy housing and gas and food and clothes. If the price of these items rises, your landlord will need to receive more rent to be able to buy the same number of items.
To more clearly illustrate this principle, let’s use another example. We’re going to make it as simple as possible, so bear with me.
Let’s say that you are a landlord in California with one rental property - a restaurant. Every month, you receive $1 in rent as per the restaurant lease. You then use this rent to buy a loaf of bread, which costs you exactly $1.
Next month, inflation increases, and the price of bread rises to $1.05. If you’re still only receiving $1 every month in rent from the restaurant tenant, you’re no longer able to afford the same amount of bread as you used to.
To compensate for this, you’ll need to raise rent to $1.05— the same amount that prices increased— so that your real income stays the same.
The idea is that, as prices increase, the purchasing power of a single dollar decreases.
To maintain the same amount of real income that they’re receiving from paying rent, landlords need to change the rent by the same amount that CPI went up, so their real income stays the same.
Because of this, landlords tend to like consumer price index rental increase clauses. They ensure that the landlord receives the same purchasing power from their leases and protects them from inflationary pressures.
So, now that we know what CPI clauses are and why they’re used, let’s talk about how they may affect you as a tenant.
There are some arguments that say increasing rent by the same percentage as CPI isn’t the fairest way to do it.
For starters, inflation and purchasing power can be heavily influenced by where you live; if the landlord is using a national CPI but you’re in an area where prices are stagnant, you might be paying more than what’s fair.
Additionally, the above example I gave above with the $1 bread might be a little too simple to be reflective of real life.
When landlords collect rent, they don’t use all of it to pay for disposable items like food.
A large portion of the rent goes towards paying off expenses such as mortgages, repairs, capital costs, and utilities.
There is no guarantee that these expenses are going to rise by the same amount as CPI. If your rent increases more than the expenses increase, your landlord will actually increase their real income. To illustrate this better, I’m going to use another example.
Say you pay $1000 in rent per month as a hair salon tenant in Florida. Out of this $1000, the landlord uses $500 to pay for expenses and takes home $500 as income.
Now say CPI goes up 5%.
Remember, CPI is the consumer price index. It reflects the price of common household expenses, like food and clothing. Just because CPI went up 5% doesn’t mean that all of the landlord’s expenses went up 5%, because mortgages and property management fees aren’t common household items (and many of the contracts with suppliers are locked in for the year).
So, say CPI increases 5%. Your landlord raises your rent 5%, so you’re now paying $1050 every month for your hair salon. But, because they’re not as impacted by inflation, the landlord’s expenses stay the same at $500. His income is now $1050-$500=$550.
The landlord’s income went up 10% ($500 to $550), even though the prices of the items he buys with that income only went up 5%.
Because of this, CPI may not be the most accurate way to judge the amount by which your rent should increase, because it may not account for geographic differences or real estate specific trends.
Additionally, you may end up paying more than what is fair, as the example above illustrated. Finally, the consumer price index can be hard to predict; if you’re trying to estimate your future costs for a pro-forma financial statement, it can be difficult to get an exact measure as to what your rent will be.
That being said, there are some advantages to having a CPI clause in your rental contract, regardless off what type of lease you sign.
As I said, landlords tend to favor clauses that peg rents to CPI. This can make your lease negotiation easier if you’re willing to accept the potential of paying more in rent. In periods of little to no inflation, CPI might increase by a very small margin, so your rents will stay relatively stable over time.
As with most things, there’s no clear answer to the question above. Whether or not the consumer price index is a good way to calculate your rental increases depends on a variety of factors surrounding your businesses, the terms of the lease, and the economic conditions you are in.
That being said, I’ve tried to create a general guide to highlight some circumstances in which you would and won’t want to use CPI as a basis for rental increases.
Here is what you need to be thinking about at the letter of intent (LOI) stage (I highly recommend you check this article on LOIs: How to Write a Letter of Intent for a Commercial Lease)
You SHOULD ask your landlord to base the renewal right on CPI if:
You SHOULD NOT base your renewal rental rate on CPI if:
CPI is far from the only metric that’s used to calculate how much your rent is going to increase from year to year. A few of the more common methods include:
To summarize what we’ve gone over in this article: