Rental Escalation: The Good, the Bad and the Ugly

Rental Escalation: The Good, the Bad and the Ugly

Category Expert Insight

Signing a lease agreement for a residential or commercial property is a significant step for most people. Whether you are a landlord securing a tenant or a tenant finding a home or business space, you are likely to find a provision for rental escalation within the clauses of the rental contract. These clauses specify how frequently and by how much (percentage based) the rent will increase during the lease period.

This may initially seem uncomplicated, but the rental escalation clause needs consideration by both parties. Seeff Properties explores the good, the bad, and the (potentially) ugly aspects of this common rental practice. As with all legal and contractual matters, it is advisable to speak to a qualified and registered real estate professional to negotiate and manage your rental contracts. Often, trying to take shortcuts and doing it yourself ends up with greater problems (and often costly) down the line.

Why the increase? Understanding the purpose and reason of Rental Escalation clauses

From a landlord's perspective, incorporating a rental escalation clause is a way ensure that their property provides a long-term, profitable return on investment. Several economic factors contribute to this need:  

• Inflation: The cost of living and operating expenses of an investment property (such as rates, taxes, insurance, and maintenance) tend to increase over time, often annually. Escalation clauses help landlords keep their rental income in line with these increasing costs, ensuring they keep a positive and profitable return on investment. Ultimately, the rental escalation acts as a buffer against inflation as the rental income will keep pace with financial demands.    
• Market Value Appreciation: In most areas, property values and consequently market rental rates will increase over time. An escalation clause allows landlords to gradually align their rental income with prevailing market conditions without having to negotiate a new rental contract each year. Market values are closely tied to the demand and supply of properties in a given area. Head of Valuations at Seeff Properties, Junior Makopola, relates this to a comparison between value appreciation in Francistown compared to Gaborone. "Currently, property values are increasing at a slower rate in areas like Francistown and as such there is a tendency that rental escalations in such areas are lower than you would find in Gaborone, for example" states Junior.   
• Predictability: For both landlords and tenants, a rental escalation clause provides a degree of financial predictability. Landlords can forecast their income, plan maintenance and renovations and anticipate their return on investment. Tenants can anticipate future rent increases, allowing better budgeting. A fixed percentage increase in annual rental is more predicable and more bearable whether the tenant is a business rental or a residential rental. This is preferable to managing sudden market driven rental hikes that can be unexpected and out of the tenants personal or business budget.     

With an understanding of why escalation clauses need to be included in rental contracts, Seeff briefly looks and the pros (the Good) and cons (the Bad) of these clauses and what happens when things go wrong (the Ugly).  

The Good: Advantages of Rental Escalation

For the Landlord:

• Maintains Profitability: As mentioned above, the escalation will help balance rising costs and will keep the investment viable over the long term.
• Reduces Negotiation Frequency: Instead of renegotiating rent annually, the escalation clause provides a pre-determined increase. This will save time and potentially minimise the risk (and associated costs) of tenant turnover.

For the Tenant:

• Predictable Budgeting: Knowing the escalation rate allows tenants to plan their finances for the duration of the lease and not be met with unexpected rental negotiations midway through their tenancy.  
• Potentially Lower Initial Rent: In some cases, landlords might offer a slightly lower initial rent knowing that it will increase predictably over time.
• Avoids Large, Unexpected Rent Hikes: Gradual, pre-determined increases are generally easier to manage than a sudden, significant rent increase upon lease renewal.

The Bad: Potential Downsides of Rental Escalation

For the Landlord:

• Market Fluctuations: If the market rental rates don't increase as anticipated (or even decrease), the pre-set escalation may cause the rent to increase above market value, potentially making the property less attractive to new tenants upon renewal.
• Tenant Dissatisfaction: Aggressive or poorly explained escalation clauses can lead to tenant dissatisfaction and potentially higher turnover in the long run. If the rental increases too much over a long tenancy, the tenant may find the rental unaffordable and leave.  

For the Tenant:

• Increased Costs Regardless of Circumstances: Even if a tenant's financial situation changes or the property's condition deteriorates, the rent will still increase according to the agreed-upon clause.
• Unfair Increases: If the escalation rate is significantly higher than the actual inflation or market value increase, tenants might feel they are being unfairly charged.

The Ugly: When Rental Escalation Goes Wrong

The "ugly" side of rental escalation emerges when the clauses are unreasonable, poorly communicated, or exploit one party. This can manifest in several ways:

• Excessive Escalation Rates: Clauses with very high percentage increases or those tied to vague or volatile indices can lead to unaffordable rent for tenants.
• Ignoring Market Realities: Applying the pre-set escalation even when the local rental market is stagnant, or declining can create significant tension.

Navigating Rental Escalation: Tips for Both Parties

• Engage a Property Practitioner: As noted at the beginning of this article, Seeff always recommends tenants and landlords engage with duly qualified and registered property practitioners. In many instances where parties try to engage in and manage their own rental contracts things can go very wrong. This can often cause unnecessary waste of time and money. Using an agent can often allow the parties to manage difficult negotiations about escalation clauses.
• Read Carefully: Both landlords and tenants must thoroughly read and understand the rental escalation clause before signing the lease. It is also essential that each page is initialled by both parties as acknowledgement of the content.
• Negotiate: Don't be afraid to negotiate the escalation rate, frequency, or the index it's tied to. Research local market trends to ensure the proposed increase is reasonable.
• Seek Clarity: Ask for clear explanations of how the escalation will be calculated and applied.
• Consider Caps: Tenants might want to negotiate a cap on the annual escalation percentage. The landlord should consider the presiding rate of inflation and ensure that they do not exceed that too much.
• Document Everything: Ensure the agreed-upon terms are clearly documented in the lease agreement.

Conclusion

Rental escalation is a common and often necessary component of property lease agreements. When implemented fairly and transparently, it can provide predictability and protect the interests of both landlords and tenants. However, the "ugly" side emerges when these clauses are unreasonable or poorly understood, leading to financial strain and disputes. By approaching rental agreements with careful consideration and open communication, both parties can navigate the nuances of rental escalation and foster a more positive and sustainable landlord-tenant relationship.

If you have any questions or queries on the matters raised above, please contact the Seeff office on 393 9372.

Author: Seeff Properties Botswana

Author: Seeff Properties Botswana