Landlords that had some time ago begun pumping the brakes on “rent steps” — rate increases that push rates higher over the lease term — are back to bearing down on the accelerator. Many tenants saw something of a reprieve from these rent steps during and after the economic downturn, as property owners concentrated on filling empty spaces rather than on maximizing rental income. “During the recession, landlords did anything they could to get deal activity,” said Jeremy Ezra, an executive vice president at RKF, in New York City. If that meant offering a flat rent for five years and then introducing a rent increase after that, then so be it, he says.
Rent escalations have for some time been a part of retail leases longer than three years. Those escalations can vary based on the size of the deal, the credit of the tenant and the quality of the shopping center. In most long-term leases, rent steps are either paid on an annual basis or they increase after a given time frame, say, every three to five years. The most common annual increases usually are about 2 or 3 percent, with five-year bumps of 10 to 15 percent.
In some cases, landlords negotiated sweetheart deals during the recession, with minimal or no rent steps, and now they are in a position to push harder for those midterm increases in new lease negotiations. “It really boils down to simple supply and demand,” said Jennifer Watson, a senior managing director at Newmark Grubb Knight Frank, in Chicago. Nationally, retail vacancy rates have improved steadily, on strong demand for space from retailers and restaurants. “Rental rates are driven up by this demand, which gives landlords more leverage in dictating higher rent steps,” she said.
As the retail sector has continued in recovery, and with retailers and retail property owners alike on a more solid footing, landlords are again turning their attention to rent steps as a means to boost cash flow. In fact, landlords in some markets are hoping to leverage strong occupancies to negotiate for bump-ups that are even higher than the historical norm. In New York City, for example, rent steps have typically been about 3 percent per year. But some landlords are pushing for 4 percent annual increases, notes Ezra. In some cases landlords are successful in getting those higher rent steps, in other cases they are not. But that effort goes to show that landlords are trying to be more aggressive at their best shopping centers to create better long-term value, he says.
Rent steps are a useful tool for landlords seeking to increase profits. Regency Centers Corp. reported in its third-quarter earnings call that it is now getting rent steps from about 90 percent of its tenants, with increases that have risen by nearly 70 basis points, to an average of 2.3 percent. At DDR Corp. 81 percent of new leases and 42 percent of renewals include rent bumps within the initial terms, the firm said on its third-quarter earnings call. “This -focus on rent steps is one of the most significant recent changes we have made as we negotiate and analyze deals, and one that we continued to leverage during the quarter,” said Paul Freddo, DDR’s senior -executive vice president of leasing and -development.
“It seems to me that landlords are more focused on rent increases than ever before,” said Ezra. “I would just caution that while things are generally good right now, retail has softened a little bit, and I want to make sure that my retail clients are not overpaying with significant increases.” The 4 percent rent steps in New York City now are not palatable for tenants, especially in the retail sector, which tends to be cyclical, he says.
Most developers and shopping center investors are underwriting rental increases at 10 to 12 percent every five years on larger spaces, 12 to 15 percent every five years on midsize spaces and 3 percent annually on smaller spaces, notes Terrison Quinn, a senior vice president and co-market leader at SRS Real Estate Partners, in Newport Beach, Calif. “That said, many developers and shorter-term investors are not focused in on bumps nearly as much as many of the long-term institutional groups that will likely hold for a longer period of time,” he said. Those long-term owners are particularly concerned about higher inflation ahead.
Landlords are trying to get options set at uncapped fair-market value, or adjusted in accordance with the consumer price index. “This has created complications with a lot of deals, because most credit tenants are not getting [real estate committee] approval without fixed, known rent increases over the initial term and options,” said Quinn. “This is especially true when a tenant is spending considerable tenant-improvement dollars on their turnkey build-out and need to amortize those costs over longer periods of time with a fixed, known rent structure.”
Many landlords unable to get consumer-price-index or fair-market-value adjustments in the options are trying to get tenants to increase rent more frequently — 6 to 7.5 percent every 30 months, say, versus 12 to 15 percent every five years, says Quinn. “We see this working in more cases now than a couple years ago, but it is not yet the norm,” he said. “At times tenants can get pushback at [real estate committee], and it can threaten the lease from getting to the finish line.”
In addition to the push for higher rent steps, there also is a notable shift among owners looking to -secure -annual rent steps. Landlords can collect more income with annual hikes, as the rent is calculated in a compounding fashion from the previous year. As the base rent grows, the amount of the increase also grows. But tenants often prefer a fixed rent for five years, with a larger increase after the fifth year, says Watson. Fixed rents are easier to budget in the tenant’s pro forma, and the increase compounds after five years instead of each year, she says.
Of course, while the rent increases help landlords boost revenues and cash flows, they are harder on tenants. Oftentimes, retailers apply their rents as a line-item expense or liability for accounting purposes. Essentially, retailers public and private have to account for their rent liability on the balance sheet. If the rent is $100,000 and a retailer has an annual increase of 3 percent, on the balance sheet it may not necessarily account for that $100,000 rent in year one. The tenant will actually run a spreadsheet on the average rent over the term of that lease and then show that average rent each year. At the beginning of the lease, when the tenant is actually paying a lower amount, there may be some benefit to cash flow, as opposed to in the latter part of the lease term, when the rent will be greater.
Ultimately, when a retailer looks at the financial viability of those locations near the end of the lease term, the higher rent liabilities during the latter part of the lease make the location look less favorable in an economic model. “It is really not in the retailer’s best interest to have these significant increases,” said Ezra.
Retailers are pushing back not just because of the way that hurts the financial model, but of late also because the market is starting to cool, Ezra says. “I think you are seeing more and more retailers slowing down and sales starting to flatten out,” he said, “and they feel like they need to stop the bleeding, so to speak, on the rent increases.”