Safeguarding for the possibility of high inflation in a lease

[Caleb Webster]

I've been listening and reading to a multiplicity of economic pundits regarding national debt, quantitative easing and other such fun things. I'm also currently negotiating several 5-10 year leases on a mixed use property of mine and the thought crossed my mind that I don't have a contingency for a high inflation scenario - my annual rent and CAM increases are 2% and 5% respectively. 

Are you accounting for the potential for higher-than-normal inflation in your leases? If so, what does this look like? 

[Joel Owens]

It depends on who your target buyer is when you exit.

Is it a jewelry box buyer? They often want 3 to 5 unit strip centers and national tenants with 5 to 10 year leases. The longer the fixed term of the lease the better lenders like loaning on a property and tend to give the best loan terms to a buyer. When the quality of tenants are high and primary lease terms are long the property tends to sell for a lower cap rate which can give a higher exit return to a developer. These jewelry box buyers often want stability and long term leases and want to avoid the ups and downs of the stock market or other asset classes where one year rents are high but other years rents are low or flat. These investors already have made many millions or tens of millions of net worth and continue to have high cash from their job or business.

Then you have the YIELD buyer. This buyer tends to want the most return and will work for it dealing with more mom and pop tenants that can require more check and balances to manage the cash flow. If that is the target purchaser upon exit than typically you want to achieve with mom and pop tenants on retail 2 to 3% rents that go up ANNUALLY. Sometimes mom and pop tenants negotiate cherry terms for themselves that only national credit tenants should ask for. Example if a buyer is taking on more risk with mom and pop tenants for rollover risk then they should be compensated with extra yield EACH YEAR they own the asset. They should not get a mom and pop tenant that negotiates Starbucks quality lease terms for TI's, 10 year fixed lease with 10% rental increase every 5 years. Even if the mom and pop tenant negotiated going up 10% every 5 years it's often not a good idea.

Mom and pop tenants are often poorer planners and their business models (especially single unit level operators) do not often plan for major increase expenses to the business. Those rent jumps even though they know it is coming can be a shock to them. Now they want to renegotiate the rent increase down some or spread it out over longer periods of time. Both can be bad situations for a property owner. You want to collect rent increase each year to help force the mom and pop tenant to constantly build in that cost so more easily absorbable over time.