SAY GOODBYE TO CPI (IN COMMERCIAL LEASES)?

Justin Lahart and Brian Blackstone (in their June 18, 2009 Wall Street Journal article: “Consumer Prices Keep Inflation in Check”) reported that consumer prices in May, 2009 posted their largest annual decline in fifty- nine years (according to the U.S. Department of Labor’s Bureau of Labor Statistics [BLS]). While the “CPI-U” rose .01 percent from May to April of this year, the CPI-U for May, 2009 was down 1.3 percent from May 2008; the largest decline since 1950.

According to the BLS, the CPI-U for the Cleveland/Akron area was 2.3 percent below its year-ago level of 2008. (By comparison, the Cleveland area CPI-U rose 4.4 percent from May 2007 to May 2008).

What is the Consumer Price Index (“CPI”)? The CPI is the most widely-used measure to determine consumer price inflation. CPI measures the average change over time in prices paid by consumers for goods and services that live in urban areas. The Bureau of Labor Statistics of the U.S. Department of Labor collects this price information and then calculates the CPI statistics. CPI is actually measured for two groups: 1) All urban consumers (CPI-U); and 2) Urban wage and clerical workers (CPI-W). CPI-W measures consumer price inflation for urban residents who live in households that receive more than half of their income from clerical or wage occupations, and have one wage earner employed for at least 37 weeks during the previous 12 month period. Urban wage and clerical workers represent a subset of the CPI-U population.
CPI-U is the most commonly-used index because it has the largest population coverage (approximately 87 percent). However, the CPI-W is frequently used to make cost-of-living adjustments for labor contracts. In addition to the U.S. CPI, the BLS publishes CPI statistics for twenty-six of the nation’s metropolitan areas.

What does CPI have to do with commercial leases? Landlords may insist upon CPI adjustments in commercial leases so that rents and common area charges (“CAM”) keep up with expenses, which typically increase because of inflation. Also, landlords and tenants often use CPI adjustments to determine what the rent during an option term should be. In the late 70’s and early 80’s, most landlords felt comfortable with CPI adjustment clauses since a change in the index ranged from six to twelve percent in those years. That comfort level remained, even as “corrective” adjustments to the index by BLS, and more currently, recessionary factors, brought CPI index changes to the two to four percent range. Now that the CPI is in negative numbers, however, typical CPI clauses are no longer helpful for most landlords, and could serve to decrease rents (if a poorly drafted provision calls for CPI adjustments vs. CPI increases).

The problem is magnified when energy, labor, and tax costs for landlords increase at a greater rate than CPI. With negative index changes, this “magnification” is guaranteed. According to UBS economist, James Sullivan (quoted in Mr. Lahart’s article), the problem is expected to continue for some time, because “inflation is not likely soon, and it will be under downward pressure for years to come” due to the current recession and unemployment rate.

So, what’s a landlord to do?

1) First and foremost, landlords should make sure that their CPI provisions call for “increases” only. Use of the word “adjustments” may result in the unintended result of receiving lower rents;

2) A CPI increase provision may still be beneficial. However, landlord and tenants should negotiate a “floor” and “ceiling” to the increases. Consider the following clause: “Notwithstanding the above, in no event shall Rent be increased by more than six percent (6%), or less than three percent (3%) over the Rent for the previous Lease Year";

3) Budget CAM charges based on the previous year, and reconcile same at the end of each lease year. For tenants that require more certainty, limit “controllable” CAM charge increases to a fixed “guesstimate”, or base same on an alternate cost analysis such as a historical average of specific CAM charges, subject to revision mid-lease;

4) For option rent, it is advised that landlords negotiate a set figure. From the landlord’s perspective, the higher the better, as an option, by nature, only obligates the landlord. The tenant has the option to accept it or reject it.

While decreasing costs is good news for consumers, landlords are advised to closely monitor expenses, and review their leases with brokers and attorneys to help ensure that “outgo” does not exceed income.