How the "Inflation Clause" Works

To examine the operation of the inflation clause we shall have to do some figuring. In order to keep it simple, we are working with round figures, not actually taken from a brochure. But the figures and assumptions correspond substantially to actual syndicate offerings. The property of the syndicate is net-leased to a tenant. The tenant collects $75,000 in rentals. He must pay all expenses, including taxes and payments on the mortgage. In addition, he must pay $40,000 yearly to the syndicate to permit distributions at the rate of 10 percent on the investment of $400,000. The net lease provides for an overage rental of equal to 20% of the tenant's annual gross receipts from the operation of the property in excess of $90,000 (after deducting any increase in real estate taxes and assessments over those now payable) and an additional 10% of the tenant's annual gross receipts in excess of $115,000.

If the rentals collected by the syndicator-tenant go up 20%, he will be collecting $90,000, (the present rent roll of $75,000 plus $15,000 representing the 20% increase). Under the provision of the long-term lease the tenant will have to pay no additional rent to the syndicate, because he has to pay 20% only on the excess over $90,000. There is no excess here. So the tenant takes in 20% higher rental, but the syndicate gets no increase. Assume now that the tenant collects rent increases amounting to 333%, that is he collects rents amounting to $100,000. Then he has to pay 20% of the excess over $90,000 to the syndicate. He will have to pay 20% of $10,000 to the syndicate, that is $2,000.

The syndicate originally collected $40,000 rent per year. With the addition of $2,000 per year it will collect $42,000. It will be possible to increase the distributions to the investors. If the investors received 10% distributions on their investment before, now they will receive 10.5%. Rents have gone up 33.3%. The yield of the investor on his return has gone up from 10% to 10.5%. Actually the picture is worse than shown by these figures, because we did not make any allowance for an increase in property taxes. Under the lease such increase would have to be paid for first, before the syndicate may get any benefits from the increase in rents.

What Benefits Do You Get from an Inflation Clause?

Suppose you have reached the conclusion that substantial rent increases may be in prospect in the reasonable future, so that some overage will go to the syndicate. You must take another look at the brochure to determine what you will get. See how the overage rent is divided between the syndicator (yes, he is also your partner in the syndicate) and the investors. It is not enough that some overage rent may be payable to the syndicate. You should get a reasonable share.
Frequently the contract will provide that a certain percentage of the overage rent will go to the General Partner (that is the Syndicator or some other insider). The rest is to be distributed among the limited partners— you and your co-investors. In the last illustration, if the general partner had the right to receive 30% of the overage rent, only 70%, or $1,400 would have been available for distribution to the other investors. The yield on their investment would have gone up even less than shown in that illustration.

Concerning inflation clauses, you must check the following. First: Is it a realistic inflation clause? Is it reasonable to expect that the future rents will be increased sufficiently to permit a distribution to the syndicate out of the overage? Second: How much will the increase to the syndicate be?
Third: If the syndicate receives an increase, how much will you get?

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