Office Lease Operating Expenses are called gotcha expenses by one of my tenant representation clients. I can see why he considers them in this vain. When we negotiated his lease we set it up so that he didn’t get caught. He gets an operating expense statement from his landlord and realizes how much money he avoided paying because the lease was negotiated properly.
It is acceptable for landlord’s to have many clauses in their leases. One typical clause is designed to provide a procedure for the Landlord to recover common area maintenance and other traditional operating expenses (property taxes, insurance, landscaping etc…) and be reimbursed by the tenant.
Electricity is usually handled differently since most multi tenant office buildings do not submitter their tenant’s offices because of the expense of a meter these expenses are either quoted in addition to the base rent or could be included in the operating expense calculation.
Negotiating Office Lease Operating Expenses
During a lease negotiation it is imperative that the office tenant understand the operating expense clause of the lease. The wording con be confusing at best and create a significant financial cost to the tenant if they are not careful.
There are traditional three ways that office lease operating expense pass throughs are designed to allow the landlord to recover the operating expense associated with an office lease.
Base Year: The base rental for the first year of the lease includes the office lease operating expenses. This first year is usually defined as the base year. In the following years any increases in the operating expenses above the first year’s expenses will be passed along to the tenant.
Triple Net: This lease requires the tenant to pay one undressed percent of their prorated share of the operating expenses associated with their office lease.
Expense Stop: this is a similar approach to the base year except the lease will usually have a certain dollar amount per foot addressed in the lease. The general idea is to state the estimated dollar amount per foot of the operating expenses.The tenant would pay their prorated share of the expenses above the expense stop.
At the beginning of each calendar year the landlord will estimate the office lease operating expenses associated with their building. The will typically issue an operating expense statement that includes the monthly estimate operating expenses associated with the office space leased by a tenant. The statement is usually delivered to the tenant in March or April of each year.
When reviewing the lease operating expense clause there are several key areas to consider. These include items that are included in the calculation, capping controllable operating expenses and grossing up the operating expenses.
One example of an item that should be given consideration is the way capital expenditures are taken into consideration. An office tenant doesn’t want the operating expenses for a year to include the replacement of a heating and air conditioning system with a twenty year useful life. Generally accepted accounting practices should be addressed in the operating expense clause. Additionally items associated with the marketing of the property or legal fees associated with matters that have nothing to do with the property operation.
A landlord should have a governor of some type that requires them to be reasonable in the operating expenses that they pass through to their office tenants. By placing a cap on controllable operating expenses the tenant has some assurance that these expenses will not increase at an unreasonable level. Controllable expenses are not associated with property insurance, utilities or taxes. They do include expenses that are more readily managed by the property manger. Examples are janitorial, landscaping or light bulbs.
An often misunderstood but very important concept is grossing up the operating expense. This clause should be included in the definition of the way that the operating expenses are calculated. This clause prevents the tenant from getting a low base year number because the building has a lower occupancy. As the building leases up the operating expenses also increase. For example a forty percent occupied office building has a lower janitorial expense than a ninety-five percent occupied building.
It is important to specifically express the percentage that the building’s office lease operating expenses will be grossed up too. It is typical that the accepted number is ninety-five percent.
As with any important transaction it is important that the office tenant representative and a competent real estate attorney assist the tenant with the negotiations.If terms and conditions like operating expenses and other important items are neglected they can cause the office tenant serious financial exposure.