A Tenant’s Guide To Operating Expense Escalations

February 8, 2013Law360

One of the largest expenses of conducting a business is rent. In the typical lease, a tenant will need to be mindful of not only any periodic fixed increases in rent, but also escalations that are based upon increases in the costs of operating, maintaining and repairing the building. The purpose of these escalations is to ensure that the “net” rent received by the landlord is not reduced by the normal inflationary type costs of operating and maintaining the building.

Charging the tenant for its pro rata share (based on the tenant’s rentable square footage in proportion to the total rentable square footage in the building) of the property’s operating costs, which are in excess of the operating costs for a certain base year (usually the calendar or fiscal year in which the lease commences), is the most common way for a landlord to protect the profit margin that was carefully calculated into the basic rent set when the lease was executed. The use of a base year (sometimes also referred to as an “expense stop”) is generally known as a “gross lease,” as distinguished from a “net lease,” where all operating expenses are paid by the tenants and the base rent is correspondingly reduced.

While this approach may seem straightforward, very often tenants are surprised when they receive the invoice for their share of operating expenses. One reason for this is that operating expenses compound over time.

For example, if the base year operating expenses are $5.00 per square foot and during the subsequent year, building operating expenses increase by 3 percent, the result is a $0.15 per square foot increase (5.00 x 103%=5.15). For a 3,500 square-foot lease, this would amount to an escalation payment of $525.00. If operating expenses again increase by 3 percent for the following year, then the result is a $0.30 per square foot increase (5.15x103%=5.30) and an escalation payment of $1,050 — more than double the previous years’ payment.

These calculations need to be considered in projecting future costs of a lease. Given this reality, it makes sense for a tenant to pay attention to the formulation of these escalation provisions to avoid overcharges and misunderstandings. There are a number of steps a tenant may take in order to minimize its exposure to unduly high increases.

Definition of “Operating Expenses”

Tenants should closely scrutinize the definition of “operating expenses” proposed to be used in their leases. The definition will generally consist of a list of inclusions and exclusions. The landlord’s definition is likely to be broad so as to attempt to capture as many expenses as possible. Not all of these expenses are properly chargeable to tenants.

Inclusions should be limited to those expenditures that relate solely the operation, maintenance and servicing of the building which are reasonable and customary for similar buildings in the surrounding area and only those expenditures that benefit all of the tenants in the building. It is important that the operating expenses not include expenses which are “ownership” costs and therefore not reasonable and customary pass through expenses such as:

  • depreciation of the building or its equipment,
  • financing expenses,
  • mortgage debt service,
  • ground rent (if any),
  • salaries for individuals beyond the level of building manager and landlord’s general overhead expenses not related to the building,
  • costs incurred in the removal or abatement of asbestos or other hazardous substances,
  • costs of complying with laws in effect as of lease commencement,
  • franchise or income taxes,
  • brokerage, advertising and other leasing expenses,
  • work done benefiting a specific tenant, and
  • items compensated for by insurance.

These items either do not benefit the tenant or represent expenditures for items that a reasonable tenant would not contemplate incurring, such as bringing a building into compliance with environmental laws.

Capital Expenditures

One of the most negotiated provisions of the operating expense definition is the extent to which capital expenditures may be included. Operating expenses customarily include repairs to the building including core building systems such the HVAC, elevators and sprinkler system. However, the replacement of these systems or costs to correct structural or design defects are not ordinary inflationary types of expenses and many tenants argue that they should be regarded as the responsibility of ownership.

These outlays provide a benefit to the property that is likely to far outrun the length of the lease. On the other hand, if the expenditure is for the purpose of modernizing a building system that will reduce operating expenses in the future, it makes sense to pass these expenses through to the tenants to the extent that they will share in the cost savings. If capital expenses are to be included in operating expenses, the following provisions should be made:

  • Capital expenses should be amortized over the useful life of the equipment (some landlord’s may try to cap).
  • Tenant should not be paying for completion of landlord improvements (in the case of new construction) or for compliance with laws presently in effect, where the building may not be in compliance.
  • Capital expenses incurred to save operating expense should only be included in operating expenses to the extent of the actual savings achieved by such expenditures.

Due Diligence

To the extent possible, a tenant should be made aware of the current and projected future cost of the lease and those areas of the lease where there is uncertainty as to what, if any, costs the tenant may incur. Tenants should examine the operating history of the building, comparable properties and other buildings owned or managed by the landlord.

Projected costs of the leasehold, which can be done by an outside broker or a financial professional, should be based on accurate assumptions reflecting the economic terms contained in the lease. One way to do this is to request a sample statement and try to obtain two recent years’ operating expense statements for comparison (the same request should be made for real estate taxes). During lease negotiations, or based on an engineering inspection, it may become clear that some base building upgrades are necessary to be made by the landlord

Gross Up Base Year

The purpose of a “gross up” provision is to neutralize distortions in the tenant’s liability for operating expenses that occur when a building is not fully occupied. To do this, the amount of actual operating expenses are increased to an amount that they would have been had the building been fully occupied. This may not sound good for the tenant, but when used properly it produces the most equitable result for both parties.

Using a simplified example: if a tenant occupies 50 percent of a building and it is the only tenant in the building and the landlord incurs a cost of $100.00 for cleaning the tenant’s space, the tenant would have to pay only $50.00 of this amount and the landlord would have to absorb the other $50.00. Without a gross up provision the tenant has avoided covering the expenses applicable to its space. If there was a gross up provision, the cleaning expense would be deemed to be $200.00 and the tenant would pay $100.00 of this amount which is the correct result.

The gross up provision can also be used to assure that the tenant is not bearing an unfair share of the occupancy costs that vary with the percentage of occupancy of the building. A tenant expects that it is paying rent for a fully operational building. If the tenant’s base year is one of the years when the building was leasing up, a later year may indicate an unusually large increase in the expense escalation.

If the expenses in the base year are not adjusted to reflect costs that would have been incurred for a fully occupied building, the tenant may end up paying more that is should. Rather than reimbursing the landlord for increases in costs due to inflation, the tenant pays for the added costs associated with having more tenants in occupancy. The key to making sure the gross up provision works for the landlord and the tenant is to clearly spell out that it applies to the Base Year as well as subsequent years.

Operating Statements and Audits

Leases typically require the tenant to pay estimated amounts on a monthly basis on account of their operating expense escalations. At the end of each calendar year during the term of the lease, the landlord provides the tenant with a statement of the actual operating expenses.

The statement prepared by the landlord should be certified by a CPA and contain substantial itemization. If the actual operating expenses are greater than the total of the estimated payments made by the tenant, then the tenant will be billed for the underpayment. If it turns out that the estimated payments made by the tenant are in excess of the actual operating expenses, the landlord should reimburse the tenant for the overage within 30 days thereafter, or as an alternative, the tenant should be allowed to offset the total rental payments due to the landlord in the amount of the overpayment.

Operating expense statements should be detailed by line items or expense categories. The tenant will need adequate time to review and if necessary, contest escalation statements. Many leases provide the tenant with only 30-60 days to object to an operating statement. However, this does not account for the reality of how many businesses operate.

The finance group or financial officer who is responsible for reviewing and responding to escalation statements may not even get to review the statement until 30 days have passed. Some larger tenants need 180 days or more to respond to an escalation statement. Additionally, many leases require that the tenant dispute the escalation statement before it has had an opportunity to review and examine the landlord’s books and records.

Many leases require that the tenant’s notice identify with particularity the respect in which the tenant claims the statement to be incorrect. However, a tenant will not be in a position to do this unless it has had an opportunity to review the landlord’s records first. The lease should permit the tenant to audit the landlord’s records and then provide the tenant with an opportunity to object to the statement. The landlord should be required to retain its books and records for a certain period of time after each calendar or lease year, and which allows the tenant to examine the books and records for accuracy. The landlord will want to incorporate confidentiality provisions.

If a discrepancy is found, the landlord should be required to immediately reimburse the tenant for any over payment, and if the discrepancy exceeds 3 percent of the operating expenses, the landlord should be required to pay for the tenant’s examination of the books and reimburse the tenant for the overage. The lease should include an effective mechanism to contest escalations statements and some method of resolving disputes (such as arbitration or a neutral CPA). The landlord will seek to limit the type of professionals who the tenant can hire to audit books and records (such as a “big four” accounting firm). The landlord will not want contingent fee consultants reviewing its books and records. Tenants are typically permitted to use an employee for this purpose.

Sunset Periods

Most leases will provide that a landlord is not precluded from billing a tenant for operating expense escalations, or correcting an operating expense statement after the end of the year to which the expense relates, even if the lease has already expired. However, it is unfair to expect a tenant to maintain contingency reserves for unlimited periods to cover these potential bills. Therefore, tenants should negotiate a “sunset” period after which the landlord is precluded from billing the tenant for the operating expenses for a particular year. Two years after the applicable calendar year is standard.

Conclusion

A commercial lease is a complex document that involves significant cost issues for tenants. A tenant who has gained a working knowledge of the concepts used to calculate the various components of its rent obligation will be in the best position to protect itself from unanticipated and improper costs.

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