Unlike the rest of the world where rentals are usually fixed with periodic reversions to market, commercial leases in South Africa escalate annually at escalation rates not linked to inflation. Globally, where escalation clauses are included in leases, the Consumer Price Index (CPI) is used for determining rental escalations. The general consensus is that linking inflation to the CPI prevents the erosion of income streams over the course of the lease.
So why does SA not follow the global norm?
The answer is historical and one linked to the cost of capital. High inflation was the norm in the 1970s, and to curb the effects of inflation, landlords imposed annual escalations based on the high inflation rate. This was done to increase the value of their property assets by continually expanding their income stream. The current inflation rate (6.6%) is just above the Reserve Bank’s target range of 3% to 6%, so why do rental escalations remain high? The answer is twofold, and relates to the cost of capital, required associated returns and yields as well as the operating costs component of recoverable income.
The contributor to escalation rates being higher than the inflation rate is operating costs rising higher than the inflation rate which puts upward pressure on the bottom line of both tenants and investors.
Property operating costs include:
- Real wage increases, which make up a high percentage of input costs such as cleaning and security services
- Increased municipal valuations, which inflate assessment rates for commercial properties and cost increases for water, electricity and refuse removal are likewise exacerbating the situation. Assessment rates and municipal services currently account for some 59% of total expenses. Rates and taxes alone account for 21% and electricity 32%. However, landlords in general recover these costs directly from the tenants
- Escalating petrol prices which increase contractor prices
- Imported input costs for items such as lifts, escalators and air-conditioning, which are affected by currency fluctuation
- Building insurance costs which have risen significantly over the last few years
However, rental escalation clauses have certain advantages for both tenants and landlords. Tenants are able to budget for rental escalations in the medium- to long- term periods while for landlords, rental escalations avoid income erosion should market conditions adversely affect rental income.