Franchisee Real Estate Lease: ESCALATION CLAUSE

An escalation clause in a commercial lease is a provision that allows the landlord to increase the franchisee's (tenant's) rent over the term of the lease.

Contact Neufeld Legal PC for franchising legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The complexity of the lease agreement for the commercial real estate that is used in the franchise operation can very easily equal, or even surpass, that of the franchise disclosure document and the franchise agreement, such that retaining the legal services of an experienced lawyer to decipher, explain and negotiate the commercial lease agreement and its schedules. And for over 25 years, we have been working with business owners, including franchisees, to understand and deal with commercial lease agreements that have been presented by landlords and are foundational to their business operations. To gain the most from our legal analysis and advice as to the commercial leasing arrangement, a franchisee would be well served to understand some of the most significant commercial leasing terminology, which we have undertaken to provide you with in-depth analysis.

An escalation clause in a commercial lease is a provision that allows the landlord to increase the franchisee's (tenant's) rent over the term of the lease. This is a standard feature in most commercial leases, as it allows landlords to keep pace with inflation and rising operating costs.

Common Types of Escalation Clauses

• Fixed or Stepped Increases: This is the most straightforward type of escalation. The lease specifies a set dollar amount or percentage by which the rent will increase at predetermined intervals, usually annually.

  • Example: "The base rent will increase by 3% on each anniversary of the lease commencement date."

  • Pros for Franchisee (Tenant): This type of clause is predictable and easy to budget for. The franchisee (tenant) knows exactly what their rent will be throughout the lease term.

  • Pros for Landlord: It's simple to administer and guarantees a consistent increase in revenue.

• Indexed Increases (e.g., CPI): This type of clause ties the rent increase to an external economic index, most commonly the Consumer Price Index (CPI). The rent is adjusted annually based on the change in the CPI.

  • Example: "The annual rent will be adjusted on the first anniversary of the lease commencement date based on the percentage change in the Consumer Price Index for All Urban Consumers (CPI-U) for the previous 12-month period."

  • Pros for Landlord: This protects the landlord's income from the effects of inflation. If inflation is high, the rent will increase to reflect that.

  • Risks for Franchisee (Tenant): This type of increase is unpredictable. In periods of high inflation, like what has been seen in recent years, this can lead to a significant and potentially unsustainable increase in rent. Franchisees (tenants) often try to negotiate a "cap" on the annual increase (e.g., "not to exceed 3% annually").

• Operating Expense Pass-Through: In a triple-net lease (NNN) or a gross lease with an expense stop, the tenant is responsible for a pro-rata share of the building's operating expenses. An escalation clause in this context requires the tenant to pay for any increase in those expenses (such as property taxes, insurance, utilities, and common area maintenance) over a certain baseline.

  • Example (Base Year Model): The tenant pays a share of operating expenses above a "base year" amount. The base year is the first full year of the lease. If operating expenses in a subsequent year exceed the base year's expenses, the tenant pays their pro-rata share of the increase.

  • Pros for Landlord: The landlord is protected from rising costs and maintains a consistent net income from the property.

  • Risks for Franchisee (Tenant): The franchisee (tenant) has little control over these costs and may face unexpected and significant increases, especially for things like property taxes or unexpected capital expenditures. It is crucial for franchisees (tenants) to carefully review the list of expenses that can be passed through and try to negotiate a cap on annual increases.

Naturally, how the concept operates in the specific context of the particular lease agreement requires experienced legal analysis, such that you make the most out of your understanding of the commercial lease agreement for your franchise. For such legal analysis and advice for your franchise and its commercial leasing arrangements, we welcome you to contact franchisee lawyer Christopher Neufeld at 403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com to schedule a confidential consultation.

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Contact us via email at chris@neufeldlegal.com or call 403-400-4092 / 905-616-8864.