What Is an Index Lease? Overview, Pros & Cons

An index lease is an agreement between the parties to a sale in which the seller holds the property until the buyer makes full payment of the purchase price. A seller with good credit and equity can often get higher payments through an index lease.

What Is an Index Lease?

A rental rate under an index lease is tied to a widely acknowledged price index that reflects increases in the cost of living. This permits landlords to increase rents in accordance with economic developments anytime the lease is reevaluated, often once a year. In contrast, a step lease requires periodic increases of a certain percentage, regardless of the cost of living at the moment.

To avoid misunderstanding, the contract for an index leasing states which index will be utilized. The Consumer Price Index (CPI) is frequently used because it represents what consumers really spend for products and services. Depending on whether a lease is residential or commercial, additional indices may also be evaluated.

What Is an Index Lease?

A measure developed and published by a third party is recommended to avoid charges of bias; neither renters nor landlords may accuse each other, for example, of seeking to alter the CPI.

Typical leases also contain a provision restricting rent increases. It may provide, for instance, that the rent cannot grow by more than 6 percent per year, even if the CPI rises by more. This clause may be placed in the contract to comply with rules regulating rent increases or to promote equity.

Tenants may be able to plan for a rent rise of up to 6 percent. A rent increase of 10 percent, for example, would be difficult to stomach if it were unexpected.

A bottom floor may also be placed on an index lease, mandating a rent rise of at least a certain percentage, such as 2 percent, which provides renters with a range to consider when estimating their rental costs for the future year. Those who are aware that the rent would increase between 2 and 6 percent based on the performance of the CPI should prepare accordingly.

When the CPI is negative, index leases do not normally decrease. The contract may stipulate that it applies just to raises. Extreme economic situations may warrant a lease renegotiation in which the tenant requests an overall decrease. This is compatible with a new index lease.

For instance, a tenant paying $10,000 USD per month might request a new index lease at $9,000 USD per month. In a weak market, established tenants with a solid track record might be in a strong position to negotiate with landlords if they are concerned about the cost of leases.

How do index leases work?

Index leases consist of four pillars: base rent, common lease indexes, a rise rate, and a growth cap. They each serve a distinct purpose in the creation of an index lease.

Base rent is the minimal amount of rent that the lessor will charge. An index of usage is a measure with the same rate of change as the index. A rate of rise is a continual addition to the base rent. A growth cap is the maximum annual rent increase allowed.

Base rent

Base rent often refers to the minimal amount of rent charged for a space with variable rent. In the event of an index lease, this is normally the same as the rent charged at the beginning of the lease or throughout the preceding period.

In other forms of leases, however, it is feasible to pay a basic rent in addition to running expenses or, in the case of retail, a percentage of sales.

What Is an Index Lease?

Common Lease Indexes

Prime:

As an index, prime represents the interest rate that banks would charge consumers with the highest credit scores.

CPI:

The CPI is the consumer price index. The CPI informs renters of the annual rent rise. Rents tend to grow annually in tandem with rising property values. Les ententes de location should specify the yearly CPI index used and the rent changes.

CPI can be changed seasonally and regionally. It is crucial to understand which area and indices are being utilized.

PPI:

The Bureau of Labor Statistics (BLS) publishes the producer price index (PPI), which is a series of indexes that calculates and depicts the average change in selling prices for domestic production over time.

LIBOR:

The London Interbank Offered Rate, or LIBOR, is a worldwide recognized benchmark rate. Major worldwide banks utilize LIBOR to lend to one another in the international interbank market for short-term loans. This index is being deprecated as institutions transition to alternative indexes.

Rent increase frequency:

The frequency of rent increases refers to how often your variable payments are scheduled to increase. The most frequent forms of rent increases occur annually or biannually.

What Is an Index Lease?

Growth cap:

Typically, landlords will not want to include a growth cap in a lease agreement. Tenants will attempt to negotiate a growth cap, though. The imposition of growth limits prevents the rent from increasing by a limitless amount.

This will prevent the renter from being required to pay an exorbitant sum that they may be unable to afford.

There are other techniques to restrict exposure to increases, including year-over-year and year-over-base comparisons. Unlike year over year, which restricts the rise to a predetermined amount over the previous year, year over base establishes a restriction for the initial year of the lease.

Calculating rent increase on an index lease: an example

(Current index value – Base index value) / Base index value is the formula to use when computing an index lease that is not a percentage, such as “Prime.” As a renter or landlord, you should use this method to determine how much rent to pay or collect. Let’s examine the application of this equation to our own integers.

Consider the current index value to be 206.7 and the base index value to be 201.5.

The rent increase calculation is: (206.7 – 201.5) / 201.5 = 0.0258

After calculating the rent increase %, add the resulting amount to the base rate as follows: $30,000 x 2.58 percent = $774

The pros and cons of using an index lease as a landlord

Pros

Using an index lease to establish the monthly rent enables it to be based on an independently published index and reduces the likelihood that tenants would contest it.

Due to the fact that everything is specified in the public index for the tenant to study prior to signing the lease, they should have a solid grasp of the lease agreement. This will ultimately result in fewer issues for both the renter and the landlord.

What Is an Index Lease?

Cons

When utilizing an index lease, it is essential to view the whole picture. The basis for rent increases should be the impact of inflation on the landlord’s costs. If the landlord want to continue generating a profit, they must comprehend how inflation will affect their spending.

The CPI index’s accuracy varies. The landlord may establish the CPI while creating the lease, but if the cost of living increases more than anticipated, the CPI will not be correct, resulting in a loss for the landlord.

Conclusion

Index Lease – A form of graded lease in which rent increases are linked to the consumer price index or another economic indicator.

What Is an Index Lease?

A rental rate under an index lease is tied to a widely acknowledged price index that reflects increases in the cost of living. This permits landlords to increase rents in accordance with economic developments anytime the lease is reevaluated, often once a year.

In contrast, a step lease requires periodic increases of a certain percentage, regardless of the cost of living at the moment.

FAQ

Consumer Price Index (CPI)
The three common indices used for calculating lease index escalations are: the Consumer Price Index (CPI), the Pro- ducer Price Index (PPI), and the Implicit Price Deflator (IPD).
There are different types of leases, but the most common types are absolute net lease, triple net lease, modified gross lease, and full-service lease.
A graduated lease is a variable lease in which the amount of rent increases periodically at regular intervals. An index lease is a variable lease that also allows for a graduated increase of rent at periodic intervals but the increases are relative to some economic indicator.
A clause providing for annual changes to the rent payable under a lease. The clause is drafted on the basis that the rent will change based upon the Retail Prices Index, although a different index can be specified.
5/5 - (1 vote)
Pat Moriarty
Follow me

Leave a Comment