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.
Breaking Down Step-Up Lease
Step-up leases are typically employed in longer-term leases spanning several years into the future. In these situations, the lessor/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 lessor responsibilities that can also increase unexpectedly, such as rising building maintenance costs due to higher labor prices.
Step-Up Leases in Practice
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. It is unusual for a residential rental agreement to have a period of over a year and rarer still to find one over two years in duration. In commercial and industrial real estate, however, companies demand long-term leases due to 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.
While rental agreements tend to be standard, commercial leases are almost always a product of 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 like 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). The lessor and lessee have different incentives, with the lessor wanting stable and cheap, and the lessor wanting to be as close to market rate over the term of the lease as possible. 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, however, both sides can end up with a step-up lease that will neither unfairly enrich or beggar one or the other.
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 lost revenue early in the contract.