What Is a Step-Up Lease?
A step-up lease is a contract that establishes future price increases for the lessee at set times throughout the life of the contract. Step-up leases are meant to protect the landlord from the risks that inflation or a rising market present for a long-term lease. Such a lease may specify, for example, a 3% increase to the base lease rate every 18 months.
- A step-up lease includes predetermined increases in rental payments that are agreed upon at lease signing.
- The step-up allows landlords to anticipate rising costs or the effects of inflation that could occur in the future.
- This type of provision is most often seen in multiyear commercial leases and rarely encountered in residential real estate.
Understanding Step-Up Leases
Step-up leases are typically employed in longer-term leases that span several years. In these situations, the lessor (i.e., landlord) takes on a significant amount of risk by locking in a lease rate. The price at which the lease is signed may not make sense if rental rates or property values in the area increase significantly over the lease period. Moreover, commercial leases can present responsibilities for the lessor that can also increase unexpectedly, such as rising building maintenance costs due to higher labor prices.
Step-up leases are almost exclusively used for commercial properties. In residential real estate, whether houses, condos, or apartments, lessors can mitigate inflation and pricing risks by the short-term focus of a rental agreement. The standard residential rental agreement term is generally one year, though some may be for shorter periods or as long as two years. In commercial and industrial real estate, however, companies demand long-term leases because of the costs involved in setting up operations, the value of establishing a well-known location, and the need for a predictable year-over-year cost. Terms vary depending on the real estate market. In Austin, Texas, for example, the commercial real estate firm Aquila says that “because Austin is one of the most competitive and fastest growing markets in the country, landlords are currently asking for lease terms between three and ten years.”
While rental agreements tend to be standard, commercial leases almost always require detailed negotiations. To create a step-up lease, the two parties must agree on the timing and rate of increases. Some step-up leases tie back to a reference, such as the average industrial rents in the area as quoted by an independent source or even the overall rate of inflation as measured by the consumer price index (CPI). These are also known as “index leases.”
In a commercial step-up lease, the lessee and lessor have different incentives. The former wants stability and low cost, while the latter wants to be as close to market rate as possible over the term of the lease.
Additional clauses in the contract may impact the step-up rates, such as a maximum yearly increase ceiling or a minimum increase requirement. Through negotiation, both sides can end up with a step-up lease that will neither unfairly enrich nor beggar one or the other.
Special Considerations: Step-Up Equipment Leasing
Step-up leases are also used in terms of equipment leasing. Although the definition is similar—periodic increases in the lease rate—the purpose of step-up equipment leasing is to give the lessee time to have the equipment and earn revenue in order to pay the higher lease rate. Step-up leases for equipment are designed to help cash-strapped businesses expand by deferring the full leasing costs into the future. Of course, there is generally a premium over standard lease rates that compensates the lessor for the revenue lost early in the contract.