A variable lease is an agreement where the payments made by a lessee fluctuate due to market conditions and other factors.
Real estate professionals must be familiar with the different types of variable leases in real estate. When learning about how variable leases work, it’s essential to gain insight from credible sources. We’re happy to put our years of experience to work and help you learn the role of variable leases in commercial real estate.
In this post, we’ll define variable leases, explain the different types, and provide examples of how they work. Keep reading for all the info you need to know!
What Is a Variable Lease in Real Estate?
A variable lease is a rental agreement where the lessee’s payments vary throughout the term due to changing market conditions.
Variable leases are most commonly used in commercial real estate. Commercial real estate refers to properties used by business owners to make a profit. Examples of commercial properties where tenants may make variable payments include:
- Office buildings
- Retail stores
- Medical centers
- Assembly plants
What Are the Two Types of Variable Leases?
There are two types of variable leases that real estate professionals must know:
- Index leases
- Graduated leases (non-index leases)
An index lease is an agreement where the rent amount is tied to an index. In most cases, the index is the Consumer Price Index (CPI), a measure of how rent prices change over time. However, the index can also refer to the local rental market conditions and other factors.
The rent price in an index lease is variable because it changes with the CPI and rental market. In most cases, tenants can expect their future payments to increase over the lease term.
For example, if a tenant is leasing an office building, their rent payments will change as the average rent prices fluctuate in their city. Because property values tend to increase over time, the payments are likely to go up.
Most index leases have a limit on rent increases. For example, an index lease may stipulate that the lessor cannot increase rent by more than 8% regardless of the CPI or market.
Other examples of indexes for this type of lease include:
- Inflation rates
- London Interbank Offered Rate (LIBOR)
- Secured Overnight Financing Rate (SOFR)
- Prime interest rate
- Treasury rates
- Fair market rents
Graduated Lease (Non-Index Lease)
A graduated lease is an agreement where the monthly rent amount increases according to an agreed-upon schedule.
One way that a graduated lease can work is based on property value. The property owner may choose to increase variable lease payments according to changes in how much the property is worth.
For example, the owner may hire an appraiser to determine the property’s value every three years. If the property value has increased, the tenant must make higher lease payments.
The property owner can also increase variable lease payments according to a schedule. In this case, the landlord and tenant agree in advance on how much and how often variable lease payments will go up.
For example, a graduated lease may stipulate that the rent increases by 4% every September. The lessor may also increase rent seasonally, such as every spring or summer. In this type of graduated lease, the tenant has a better idea of how much their future lease payments will cost.
Example of a Variable Lease in Real Estate
Richard is a new business owner interested in renting out an office space. He hopes to enter a lease agreement with an initial low rate while he gets his business off the ground.
Teresa is a real estate investor who owns an office building. She proposes to Richard a 15-year graduated lease agreement with discounted initial rates. Per the agreement, Richard’s variable lease payments will increase every five years when the property value is reassessed.
This deal is an example of a graduated lease in commercial real estate. Richard and Teresa both benefit from the agreement; Richard pays a lower initial variable lease payment, and Teresa earns income from monthly rental payments.
Pros and Cons of Variable Leases
Let’s discuss the advantages and disadvantages of the different variable leases.
Pros and Cons of an Index Lease
Landlords benefit from index leases because tenants are less likely to dispute rent costs. Because the rent is based on independent indexes, tenants cannot negotiate their lease payments down much lower. The leasing terms in an index lease are transparent, resulting in fewer problems between the lessor and the lessee.
One drawback of index leases is that both parties are vulnerable to fluctuations in the rental market. If inflation causes prices to go up, tenants will have to make higher lease payments. An index lease can also be problematic for landlords, as the CPI is sometimes inaccurate. Inaccuracies with the index can lead to landlords losing out on money.
Pros and Cons of a Graduated Lease
Graduated leases are an excellent long-term investment for landlords, as property values tend to increase over time. As the property value increases, the landlord can keep raising the rent. A graduated lease is also beneficial for tenants, as they generally receive a discounted rate in the beginning. This helps new business owners looking to lease property for a reasonable price.
One drawback of a graduated lease is that landlords can lose money if the property value does not increase. For this reason, landlords must invest in properties where the value will appreciate over time. A drawback of graduated leases for tenants is that variable lease payments increase over time, causing them to spend more money in the long run.
Check out this table for a clear breakdown of the pros and cons of each variable lease type:
|Pros for Landlords
|Cons for Landlords
|Pros for Tenants
|Cons for Tenants
What Is the Accounting Standard Update (Topic 842)?
The Financial Accounting Standards Board (FASB) is an organization that establishes financial reporting and lease accounting standards. In 2016, the FASB issued the Accounting Standard Update (Topic 842).
This update changed how variable leases are calculated when determining lease liability. A lease liability is a lessee’s financial obligation when making lease payments.
According to this update, variable payments that depend on a reference index are not included when calculating the lease liability. A lease liability only calculates variable rent payments if they rely on an index.
How to Calculate a Variable Lease
To calculate variable lease payments, divide the new index rate by the original index rate. The original index rate is set at the beginning of the lease term, and the new index rate is what it increases to. Then, multiply by the square footage of the rental property. The answer is the new rental rate for the variable lease.
The equation looks like this: New Index/Original Index X Original Rate= New Rental Payment Amount
Let’s look at an example to understand how to calculate variable lease payments.
Say that a business owner signs a five-year variable lease agreement for space in an office building. The first year of the lease calls for a rent of 30 square feet with a beginning index of 190. At the beginning of the lease’s second year, the index increases to 200.
In this example, the equation would look like this:
200/190 x 30= $31.58.
The final solution is the new variable lease payment.
Frequently Asked Questions
Let’s answer some questions real estate students frequently have about variable lease payments in real estate.
Who Benefits the Most From a Graduated Lease?
The property owner usually benefits the most from a graduated lease. Because property values tend to increase over time, the landlord can continually increase the cost of the variable lease payments.
This makes graduated leases an excellent long-term investment for property owners.
What Is the Consumer Price Index?
According to the U.S. Bureau of Labor Statistics, the Consumer Price Index measures the average changes in prices paid by urban consumers.
In real estate specifically, the CPI tracks rental and housing market changes. This index provides homebuyers, sellers, and real estate professionals with the average prices for houses and rental properties in their region.
Fixed vs. Variable Lease: What’s the Difference?
A fixed lease is a rental agreement where a tenant rents a property for a specific time. In a fixed lease, the lessor cannot increase rent prices or change any lease terms. This is the opposite of a variable lease, where the base rent changes periodically.
What Are In-Substance Fixed Payments?
Some lease agreements include payments that may seem variable but are fixed. These types of payments are called in-substance fixed payments.
For example, a tenant may have a choice of monthly payment options, but each monthly payment is a fixed price. Even though there is some flexibility regarding which payment the tenant makes, these are not variable payments.
Other leases stipulate that payments vary based on usage, but these are also not variable lease payments. In these types of leases, there is still a fixed minimum requirement that tenants must pay each month.
What to Know Before the Real Estate Exam
A variable lease is a rental agreement where the lease payments vary over time due to changing market conditions.
Real estate students must learn how variable lease payments work before the exam. Now that you understand the difference between an index and a graduated lease, you’re closer to becoming a real estate expert.
Of course, there is still much to learn before the day of the test. You can study other vital terms using our online Real Estate Flashcards!