An index lease ties a rental rate to a commonly accepted pricing index that reflects changes in cost of living. This allows landlords to raise the rents in conjunction with changes in the economy whenever the lease is reevaluated, which is typically once a year. In contrast, a step lease mandates periodic increases of a set amount of percentage, no matter what the cost of living may be at that point in time.
The contract for an index lease specifies which index shall be used, to prevent any confusion. The Consumer Price Index (CPI) is a common choice, because it reflects what consumers are actually paying for goods and services in the economy. Depending on whether a lease is residential or commercial, other indices may be considered as well. A metric devised and reported by a third party is preferred to avoid accusations of bias; neither tenants nor landlords can accuse each other of attempting to change the CPI, for example.
Typically the lease also includes a clause limiting rent increases. It may state, for example, that the rent cannot rise by more than 6%, even if the CPI increases by more than that in a year. This portion of the contract may be included to adhere with laws limiting rent increases, or in the interest of fairness.
A 10% rent increase, for example, would be hard to bear if it wasn’t expected, while tenants may be able to plan for an increase as much as 6%. A bottom floor might also be put on the index lease, mandating that the rent increase by at least a set amount, like 2%, which creates a range for tenants to consider in estimates of rental expenses in the coming year. Someone knowing the rent will rise by between 2% and 6%, depending on the performance of the CPI, can plan accordingly.
When the CPI is negative, an index lease typically doesn’t drop. The contract may specify that it only applies to increases. Drastic economic conditions might merit a renegotiation of the lease, where the tenant asks for an overall reduction. This can be tied to a new index lease. Someone paying $10,000 United States Dollars (USD), for example, could ask for a index new lease at $9,000 USD per month. Established tenants with a good record can be in a strong position for bargaining with landlords if they have concerns about high leases in a soft market.