Putting a CPI (Consumer Price Index) escalation clause in a lease is to make the lease fair to both the tenant and the property owner.
A primary benefit of escalation clauses is they help protect against diminishing purchasing power related to inflation. The CPI measures monthly the average change in the prices consumers pay for certain goods and services such as oil and gas, healthcare, food, and housing.
Commercial leases commonly provide that while rents will follow the CPI upward, they will remain the same when the CPI goes down. Landlords will argue that this is necessary because the CPI rarely declines and the one-way provision is necessary in leases when the owner obtains financing. Institutional lenders are always concerned that the income stream from a property not be subject to decreases due to lease provisions.
CPI clauses operate in one of two ways in the calculation of annual changes. The most common in use is the “yearly method”. At the end of the year, the rent is increased by the amount of the increase in the CPI in the previous year. So, the rent each year is raised to a new level and this is the basis for the next year’s adjustment.
The other method is the “cumulative method.” Using this, the initial rent (at lease commencement) is increased each year by the change in the CPI between the beginning of the lease term and the current year. In other words, each CPI adjustment reflects the cumulative CPI increase since the beginning of the lease term. When the CPI rises steadily throughout the lease term, both methods yield the same results.
However, if the CPI declines in a year and then increases in the following year, and if the lease contains a one-way provision, the cumulative method favors the tenant. This is because using the cumulative change in the CPI means that declines are included as well as increases in the total. By comparison, under the yearly method, the tenant loses the benefit of a year in which the CPI has declined.