Commercial Tenants and the Tax Escalator

One strategy for accomplishing this, of course, is to step the rent up every year or two to keep pace with inflation. Another is to make the commercial tenant responsible for unpredictable expenses, such as repairs in the space, as well as for typical things like cleaning, waste removal, decorating, water and utility costs, hot water and even heat.

And once these items have been accounted for? Go to the remaining big variable expense: the real-estate tax.

Step on the Escalator

Since the real estate tax is based on the assessed value of the building, and the commercial space is part of that value, a portion of the tax bill is attributable to the commercial space. And since tax rates have been known to increase, a board must protect its building's income stream by making sure the lease has a tax-escalation clause.

A tax-escalation clause is a lease provision in the that makes the commercial tenant responsible for paying his portion of any tax increase. Including such a clause can result in large returns for the building. Excluding them, or including them incorrectly, can cost you money to which you would have otherwise been entitled.

Tax-escalation clauses consist of several components. Generally, tenants agree to pay their portions of the increases in real estate taxes over the life of the lease. A well-drawn clause

• carefully defines the term “real-estate tax” to assure that all impositions by the authorities are included,

• fixes the amount of the taxes over which the increases will be calculated (sometimes called the "base taxes"), and

• states what percentage of the building's tax increase the commercial tenant must pay.

The base taxes are those payable during the initial year of a lease, typically is called the  "base year"). If the taxes in any year after the base year are higher than the base taxes, then the tenants are responsible for paying their proportionate share of the increase.

Abatement Department

One issue to consider involves the co-op abatement allowed by New York City during the last several years. The abatement program is designed to compensate owners of cooperative apartments for the higher rates of real-estate taxes their buildings pay compared to one-family homeowners. Under the law, co-ops must pass along the abatements to the shareholders penny-for-penny. You cannot charge a commercial tenant for increased taxes without reducing them for the amount of the abatement.

Boards are sometimes lax about the details of the tax-escalation clause. You should not be, since it can make a big difference in the amount of rent over the life of the lease. For example, if a lease is to be negotiated in August 2008, the most appropriate base year would be July 1, 2008 - June 30, 2009. The tenant might ask for the base year to be 2009 to 2010 instead. But if the board agrees to this, it will reduce the income each year for the life of the lease.

Let's say you receive $2,500 for 2008-2009. Assuming a five percent annual increase, you'd receive $2,625 for 2009-2010. If the base year were 2009-2010, however, you'd have lost not just the first year's $2,500 , but the additional $125 for the second year, and so on as the base for the five percent grows. Over 10 years, that’s a great deal of money.

As to that percentage: Typically, it is calculated based on how much of the building's total square footage that the commercial space represents. If this has not been measured correctly, you might be collecting less rent than you're due. Boards with commercial space should review how the percentage for each tenant was arrived at, and make any necessary corrections.

Call It Rent

The tax escalation should be specifically called "additional rent" in the lease. That way, if it is not paid, the tenant can be evicted. Without this language, the board may be limited to suing the tenant for the money.

Finally, remember that the best-written tax-escalation clause is worthless if the rent is not collected. A co-op client of ours recently changed managing agents. In reviewing the commercial lease to determine how much to bill the tenant, the new manager noticed the tax-escalation clause. After its initial 20-year term had expired, the lease had been renewed for 15 years. There had been a big dispute about the rent during the renewal period. After the arbitration, the previous managing agent had billed the new rent determined by the arbitrator — but did not include the tax escalation. And so the base year for the tax escalation was the year at the beginning of the first 20-year term. The tax-escalation rent that had not been billed for the first five years of the renewal period totaled over $58,000.

Be vigilant, and review your commercial leases. Otherwise, you could be missing out on a fortune.

Howard Schecter is a partner at Schechter & Brucker.

Adapted from Habitat February 2008. For the complete article and more, join our Archive >>