2% rent escalation clauses in 20yr NNN leases in the age of high inflation
I'm looking at a lot of commercial NNN listings with leases that have "rare, amazing 2% annual increases" over the 20 years of the lease term. While this may have sounded good a few years ago, 2% means that after 20 years, the rent will only be 48% higher than what it was in the first year. In an age where 10% inflation per year might be normal, the 2% annual increase is nothing.

As a buyer of commercial real estate, how should I view these leases? They seem almost worthless now, especially if the term is 20 years. Would commercial tenants agree to a lease with rent escalations that are tied to the CPI? I think we haven't seen that because people just assumed CPI is always equal to 2%. Guess what, now it might be 10%-20% per year.
[{"id": "ieav2tn", "text": "Well no tenants who have already signed their leases are going to volunteer up CPI. If more buyers are like you we will see changes in the yields people get on deals and maybe, long term, how leases are structured on escalations. If more buyers aren\u2019t like you, then you\u2019ll just miss out on deals for a while as you\u2019re on the sidelines and others see inflation as a short term problem. Will be interesting to see which side wins (price correction versus no price correction).", "replies": [{"id": "iedrhjs", "text": "I'd add the owner side.  Just had a small update from our PM that we're seeing leasing activity pick up which they're seeing as tenants looking to lock. \n\nTo use your rubric it will be interesting to see if more landlords go to - and tenants accept - stronger annual bumps (we're generally 3%) or CPI.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ieb4l8o", "text": "Run a dcf with multiple scenarios for inflation. Rent steps are meaningless if you arent doing a dcf. \n\nAlso you have to remeber having a higher rent step just creates risk of bk if it becomes unaffordable. So if your step is too low, bake into the price. If steps are too high, bake it into the discount rate with a surprise mark to market at some point. Its also why its important to not sign leases with shellcorp 123 even if its a big company.\n\nAdd: CPI increases are uncommon, although normal in europe. Biggest issue with a CPI increase is that you have no idea what your rent will be. When you get a fixed rate mortgage you want to make sure you arent having wild swings. Most generic commercial tenants prefer low fixed rates as well. Its more common on the mall side to see more variable rental terms, including % rent and bigger steps.", "replies": [{"id": "iebqajk", "text": "&gt;its important to not sign leases with shellcorp 123 even if its a big company\n\nThis cannot be emphasized enough. It's all about the creditworthiness. I'd add that PGs can help but are similarly limited by the creditworthiness of the guarantor.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ieb5eey", "text": "Mine have said *\"CPI or 4%, whichever is higher\"* for 15 years.  Never had a complaint.", "replies": [], "depth": 1}, {"id": "ieb9hkz", "text": "That's one reason why cap rates are increasing, because this return is less attractive vs. inflation. Nobody is signing anything long term tied to CPI without a reasonable ceiling. We're living in a very high inflation period but nothing indicates that that's going to sustain mid-long term..", "replies": [], "depth": 1}, {"id": "iedmyez", "text": "Plenty of people do CPI leases, especially for ground leases or long term leases, but what's done is done.\n\nYou could run a quick DCF but if you are thinking 10-20% inflation on a longer term go-forward basis you may as well pass on any deals that are longer term / not tied to CPI because you wont be able to compete with others.  I think most people are expecting inflation to settle down in the next 18-24 months. For example 10-year treasury today is at 2.99%, while the 10-year TIPS (inflation adjusted) bond is at Inflation + 0.65% so market is forecasting 2.34% inflation over 10yrs.", "replies": [], "depth": 1}]