Whether you rent office space, a warehouse, or a retail store, your real estate lease probably has language that ties the rent you pay to the Consumer Price Index. The idea is meant to benefit only the landlord, and helps the rental income retain its purchasing power. The problem is that there is more than one Consumer Price Index and there are different ways to calculate each, so make sure your lease agreement contains language that is very specific. One example of lease language referencing the CPI is:
Method #1-All Urban Consumers (Current)-Consists of all urban households in Metropolitan Statistical Areas (MSAs) and in urban places of 2,500 inhabitants or more. Nonfarm consumers living in rural areas within MSAs are included, but the index excludes rural nonmetropolitan consumers and the military and institutional population.
Method #2-Urban Wage Earners and Clerical Workers (Current)-Consists of consumer units with clerical workers, sales workers, protective and other service workers, laborers, or construction workers. More than one-half of the consumer units income has to be earned from these occupations, and at least one of the members must be employed for 37 weeks or more in an eligible occupation.
Method #3-All Urban Consumers (Chained)-The urban consumer population is deemed by many as a better representative measure of the general public because 90% of the country’s population lives in urban areas. Using chained CPI means the rate at which Social Security benefits tick up would be slower, because it reflects substitutions consumers would make in response to rising prices of certain items. Therein lies the “chained” part of the name. The metric utilizes a basket of goods and services that are measured changes from month to month; much like a daisy chain. If the cost of a certain form of transportation goes up, for example, people might switch to another kind. This kind of “substitution” is part of what is factored into chained CPI.
Method #4-Average Price Data-Calculated for specific items such as household fuel, motor fuel, and food items from prices collected for the Consumer Price Index (CPI). Average prices are best used to measure the price level in a particular month, not to measure price change over time.
In calculating the CPI, the urban portion of the United States is divided into 38 geographic areas called index areas, and the set of all goods and services purchased by consumers is divided into 211 categories called item strata. This results in 8,018 (38 × 211) combinations.
The CPI is calculated in two stages. The first stage is the calculation of basic indexes, which show the average price change of the items within each of the 8,018 CPI item-area combinations. At the second stage, aggregate indexes are produced by averaging across subsets of the 8,018 CPI item–area combinations.
Percent changes for periods other than 1 year often are expressed as annualized percentages. Annualized percent changes indicate what the change would be if the CPI continued to change at the same rate each month over a 12-month period. These are calculated using the standard formula for compound growth:
The CPI represents all goods and services purchased for consumption by the reference population with all expenditure items divided into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:
The Bureau of Labor Statistics, under the Department of Labor, releases the latest Consumer Price Index numbers, using the All Urban Consumers Index which increased 0.8 percent in February 2022, but this was for only one month. The seasonally adjusted CPI number for the last 12 months increased 7.9 percent, due mostly to an unadjusted 38 percent increase in gas and a 41 percent increase in used car prices.
Some categories increased prices dramatically the last month while other category price increases were small, which is why the CPI can be misleading. The categories of gas and fuel oil increased the most; however, the categories of medical care and food away from home increased only slightly and electricity and used car prices actually fell. These numbers are only for one month, and a commercial real estate lease should use the annual number. The all items index rose 7.9 percent for the 12 months ending February 2022, but the index for all items less food and energy rose 6.4 percent. The food index rose 7.9 percent while medical care prices only rose 2.4 percent.
Inflation is not what it used to be. In the 1980s the CPI approached 20% and the greatest economist alive said it was going to 25 percent. It went to 2 percent. Our economy today has been driven by a different wage/price spiral over the last 40 years, resulting in low inflation which helps borrowers but hurts landlords and savers. Building in a CPI adjustment can still make a difference in a long term real estate lease, as shown in the table below which compares a 1 percent CPI to a 2 percent CPI adjustment over a 25 year time frame. In the scenario below, 1 percent incremental rate increase annually results in $378,000 additional income over the 25 year span, and assuming a 10 percent Capitalization Rate, increases the market value of the property $338,000, or 26%.
In leasing any type of property, whether you are the landlord or the tenant, make sure your lease is clear about what the rent is, and what inflation adjustments apply to the rent. Even though some parties say they use a standard lease, there is no such thing. A lease is an agreement between two parties, and you should revise it to include language that works for you. As always, consult an expert.
