How do you analyze inflation and rent escalation in commercial leases?

1 What is inflation and rent escalation?

Inflation is the general increase in the prices of goods and services over time. It reduces the purchasing power of money and affects the real value of future cash flows. Rent escalation is the increase in the rent payments over the term of the lease. It reflects the changes in the market conditions, the operating costs, and the inflation rate. Rent escalation can be fixed, variable, or indexed to a certain benchmark, such as the Consumer Price Index (CPI).

2 How are inflation and rent escalation measured?

Inflation and rent escalation are usually measured as annual percentage rates. For example, if the inflation rate is 2% per year, it means that the average price level increases by 2% every year. If the rent escalation rate is 3% per year, it means that the rent payments increase by 3% every year. To compare different inflation and rent escalation rates, you can use the compound annual growth rate (CAGR), which is the average annual rate that grows a value from its initial to its final amount.

3 How are inflation and rent escalation incorporated into commercial lease analysis?

Inflation and rent escalation are incorporated into commercial lease analysis by adjusting the nominal cash flows to reflect their real value. Nominal cash flows are the actual amounts of money paid or received over time. Real cash flows are the nominal cash flows adjusted for inflation, using a discount factor based on the inflation rate. Real cash flows represent the constant purchasing power of money over time. By using real cash flows, you can compare the net present value (NPV) and the internal rate of return (IRR) of different lease options more accurately.

4 How do you calculate the discount factor for inflation?

The discount factor for inflation is the factor that converts a nominal cash flow in a given year to its real value in the base year. It is calculated as follows: discount factor = 1 / (1 + inflation rate) ^ (number of years from base year) For example, if the inflation rate is 2% per year and the base year is 2020, the discount factor for a nominal cash flow in 2022 is: discount factor = 1 / (1 + 0.02) ^ (2022 - 2020) = 0.961 This means that a nominal cash flow of $1,000 in 2022 is equivalent to a real cash flow of $961 in 2020.

5 How do you calculate the real rent escalation rate?

The real rent escalation rate is the rate that increases the real rent payments over time, after accounting for inflation. It is calculated as follows: real rent escalation rate = (1 + nominal rent escalation rate) / (1 + inflation rate) - 1 For example, if the nominal rent escalation rate is 3% per year and the inflation rate is 2% per year, the real rent escalation rate is: real rent escalation rate = (1 + 0.03) / (1 + 0.02) - 1 = 0.0098 This means that the real rent payments increase by 0.98% every year.

6 How do you compare different lease options with inflation and rent escalation?

To compare different lease options with inflation and rent escalation, you need to calculate the NPV and the IRR of each option using real cash flows. The NPV is the sum of the discounted real cash flows over the lease term. The IRR is the discount rate that makes the NPV equal to zero. The higher the NPV and the IRR, the more favorable the lease option. You can use a spreadsheet or a financial calculator to perform these calculations.

7 Here’s what else to consider

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