How to adjust index-based expenses

Tessa Author

Effortlessly update your expenses for the index-based escalations with three easy steps covered in this post.

In the face of recently confirmed FASB’s decisions not to alter accounting for index-based variable rents, I thought it might be appropriate to dedicate a post to share how I handle these in my lease administration practice.

It’s one of the more intimidating lease admin tasks. And, there are two main reasons for that: 

#1: The actual task of validating the calculation can be intense. Updating expenses for the change in index tests many lease analysts’ skills, from interpretation to finding the right information, accurately calculating new rent, and then finally updating the lease record.

#2: You’re updating Base Rent, which inherently adds pressure since it drives the lease obligation. And now, per the new lease accounting standards, the base rent is placed on the balance sheet, amplifying the importance and pressure.

Yes, there are many moving pieces when updating the rents for a change in the index. But don’t worry! In this post, I cover the basics you need to get started with index-based rent escalations. 

Let’s start by defining the Consumer Price Index (CPI) and its relationship with the base rent to understand why to use it in leases. Then, I’ll share my three simple steps to adjust the lease record for the escalation.

What is CPI 

CPI is a measure of price change for a basket of goods over time. We know it better as inflation. Bureau of Labor Statistics tracks and publishes several price indices, amongst other statistical data, in the United States.

Inflation is variable in nature. Although we can estimate how much the market value will change, no one has a crystal ball to know for sure.

Why use it in leases

Step-ups in rent are common to account for the increase in market value. The majority of leases have a fixed rent schedule, so the tenant knows how much rent they will have to pay over the lease terms. 

Adjusting rent for indexation is opposite to the fixed rate. Although parties agree on the initial rental rate, all future escalations reflect the variable change in the index. In this case, use only the initial base rent known at lease commencement to calculate the lease obligation for the term. All future escalations are expensed as incurred under the U.S. GAAP as covered in this post.

Therefore, using indexation for rent escalations aligns rent value with inflation, reflecting the change in market value. And, all else is equal, the index-based leases have a lower balance sheet impact than their fixed-rate counterparts, yet the difference is immaterial to most companies. 

The three-step process

Adjusting index-based expenses is a prevalent lease administration task that requires attention, due diligence, and elementary arithmetic skills. The good news is that there are only three main steps to this process.

#1: Gather information

To properly validate escalation calculation, you need to gather the right data. It’s essential to find the correct provision in the lease (or lease abstract) to pull the right index table, subsequently used to calculate the new rent. 

Start by locating the right provision in the lease. It will explain how and when to adjust rental expenses for the change in the index. For example, you’ll need to know the effective date and the frequency, meaning when to adjust the costs and how often. 

You’re also looking for the description of the index for the calculation. There are many different ones, yet the lease is usually very prescriptive in the name and description of the index and the issuing agency. 

Finally, you’ll need the then-current expense amount to escalate, usually found in the lease abstract, or look up the breakdown of the last payment issued.  

And, remember that although typically only base rent is updated per indexation, occasionally, multiple expense categories are affected by the escalation and must be edited.

#2: Perform the calculation

In this step, the rubber meets the road - you’re calculating expenses to pay from now on. Don’t take the landlord’s number for granted, do your own work and compare results.  

It’s important to remember that errors in escalation calculations are widespread, and their effects are compounding since you use last year’s numbers to calculate expenses for the next year.

Follow the lease language, using all of the information collected. The lease provision should spell out how to calculate the adjustment and sometimes even shows an example. 

In the most typical, year-over-year type of adjustment, the annual percentage change is applied to then-current rent to calculate the new amount. 

The formula is in the name “year-over-year,” where you divide the current year’s index over the prior year’s index to calculate the change (inflation) from last year’s to this and escalate rental expenses by that factor.

Often, be prepared to pay a retroactive balance as landlords typically late with escalation notices or if you miss the rent roll for the month. Here, you’ll need to know the incremental change in rent (the difference between new and old amounts) to process a one-time adjustment for the period retroactive to the effective date. 

If you’re a visual learner when it comes to math and formulas, take this free CPI-based escalations mini-course where I walk you through this process using an example and share my best practices to simplify it even further.

#3: Update lease record

To finalize the process, you need to make sure that the new rent amount is set up for future payments and reports generated by the lease database. A timely update to the information is essential to the usefulness of the lease data. Remember that index-based escalations affect more than just the rent roll, especially for international locations. Here are a few items essential to update:

Recurring monthly expense

Depending on how you’re using your real estate database, You can either add the full amount of the new expense or just the incremental difference.

If you’re using your real estate database for lease accounting, there’s a preference for the latter method in GAAP reporters. You’ll need to keep the initial rent going as your fixed rent feeding the schedule. The future index-based escalations will be accounted for separately as a period expense on the income statement (P&L).

Also, don’t forget to update the sales tax, VAT, or any other tax or expense that changes when the rental amount changes in your recurring rent schedule.

One-time retroactive payment

Here, you’ll need to know if it’s included with your recurring rent or paid and recorded somewhere separately. 

Also, considering reporting and the rent roll, determine if the rent schedule in the lease database reflects the rental obligation timing or payment history. 

Suppose your recurring rent schedule does not reflect the historical rent paid. In that case, one could justify updating your lease record to show new escalated rent as of the effective date without a separate line for retroactive balance, even though you updated the system later.

However, if you want to track the rental payment history and show that you updated the rental amount and paid the retroactive balance after the effective date, then include a one-time payment in the rent schedule. 

Also, figuring out how to treat the one-time retro payment will help determine how and when you start your new recurring expense. 

Key dates report

The final item section to update is the Key Dates information if you track reminders about upcoming escalations, which you should. You’ll want to mark that this year’s adjustment is complete and, depending on the method you manage Key Dates, schedule a reminder for the next year. 

Simple Process, Easy Work

As you can see, this is one process that tests all of your skills, yet it’s pretty simple once it’s broken down into exact steps. Once you collect the right information, the calculation is spelled out in the lease and is relatively easy. Then, update the lease record, and you’re good to go. 

And, to help you with the adjustment process, I’ve created the Index-based escalation worksheet. Download it to gather the right data and complete the calculation without hassle and confusion. It’s a one-pager you can easily include as support for your adjustment. 

Categories: : Rent Roll, Lease Data