Commercial tenants are often shocked when they receive an operating expense statement from their landlord. Some of this is as a result of poorly drafted operating expense clauses. In other situations, it is as a result of erroneous charges. Below are some clauses to look for and the impact that may have on your lease.
Services Included in Rent
The lease must be clear in defining the services the landlord is to provide at its sole expense as part of the base rent. In the absence of negotiating a “laundry list,” it may be acceptable to state that the landlord shall provide all of the building services that are usually provided in a same class office building in the same geographic area.
Operating Expense Escalation Clause
The purpose of an operating expense escalation clause is to allow the landlord to recover “normal” inflationary-type cost increases attributable to the services the landlord has agreed to provide. That should be all the clause does. Operating expenses should correspond directly to benefits gained under the lease and they should meet an objective standard such as GAAP (generally accepted accounting. principles), not conventions particular to the landlord.
In order to determine the appropriate proportionate share of the building’s operating expenses for which you are responsible, the lease should clearly state the basis upon which such share was calculated (usually the ratio which represents the rentable square feet of your demised premises in relation to the total rentable square feet of the building). Although rentable area is used to calculate your base rent and pro rata share, the usable area of your premises may be considerably less than this amount. Normally, you’ll be able to use only 75-90% of what you pay for. Therefore, the calculation of rentable versus usable area should be carefully analyzed during the lease negotiations. The landlord should document how both the usable and rentable area were calculated, supplying specific information regarding the measurement standard used. (In most cases this measurement standard will be the so called BOMA standard or a variation of it.) The lease should allow for a verification of the actual rentable footage subsequent to the completion of the tenant improvements and an adjustment of the base rent to reflect the final measurement.
Base Operating Expenses
Typically, a tenant is required to pay its share of the increase in operating expenses over a base amount. This base amount may be presented in the lease as a per square foot amount (Le., $4.25), a fixed dollar amount (l.e., $325,000) or the actual expenses incurred during a particular year. Although it may seem desirable to simply state the base amount as a fixed per square foot or total dollar amount, this presentation must be carefully analyzed in order to determine the basis upon which the fixed amount was derived.
The base operating expenses should be defined to comprise all costs of operating the building at a normal level, i.e., all normal costs of operations should be included and adjustments should be made to compensate for any atypical costs that show up (or do not show up) in the calculation of this amount. In this way, the tenant will only pay for the true inflationary-type cost increases as is intended by the escalation clause. For this reason, the preferred presentation of base operating expenses is to utilize the actual operating expenses of a particular year. The actual expenses incurred can easily be measured against the aforementioned criteria to determine if they represent “normal” expenses.
Summarized below, are some of the more common adjustments required to be made to base year expenses in order for them to truly represent costs for a “normal” or “typical” year:
a. Occupancy — Base year expenses should reflect the expenses that would have been incurred had the building been occupied at a normal (full) level. We recommend seeking a 100% occupancy level for this purpose, but recognize that in a multi-tenanted building, the “normal” full occupancy level may be more like 90-95%.
b. Warranties – In a building of new construction, many of the building systems are under warranty. Consequently, the cost of maintaining such equipment during the warranty period is lower than during normal maintenance periods. Thus, the lease should provide that base year expenses should be adjusted to reflect normal maintenance costs in the absence of any warranties.
c. New Services — In the event the landlord wishes to add a new service to the building, the cost of such service the first year it appears should be added to the Base so that the operating expense escalations do not include the entire cost of such service. In the absence of adding such service to the Base, the cost should be excluded from the escalation unless the tenant’s consent to adding the service at its expense was given.
d. Management Fees — Management fees are usually calculated based upon a percentage of total rents collected. Such percentage should not be permitted to increase where the relationship between the owner and management company is not arms-length. In a newly operational building, the base year rent collections may be artificially low due to rental abatements and/or the absence of rent escalation payments. The lease should provide that management fees in the base year be calculated from rent collections prior to any rent abatements and inclusive of a reasonable estimate for additional operating expense and tax escalation rents.
e. Real Estate Taxes – In a building of new construction (or newly renovated) base year real estate taxes may be based on a partial or incomplete assessment. The lease should provide that the base year for real estate taxes be the first year after the lease commencement in which the building has been assessed as fully complete and operational.
Exclusions from Operating Expenses
The lease should require that annual “Operating Expenses” exclude the following:
a. Capital Expenditures, which shall include any capital replacements, capital repairs or capital improvements made to the land, Building or Building system or systems. Replacement of an item, replacement of a major component of an item and major repairs to such item in lieu of replacement shall each be considered a Capital Expenditure if the original item itself was capitalized on the books of the Building Owner as part of the original construction or acquisition cost of the Building or of a subsequent improvement made thereto.
Notwithstanding the foregoing, Building Operating. costs may include Capital Expenditures of $1,000 or less. Any Capital Expenditure in excess of $1,000 will be Landlord’s sole responsibility.
For purposes of this clause, a group of expenditures related to the same project will be considered a single expenditure. Lease payments for rental equipment, the cost of which equipment constitutes a capital expenditure if the equipment were purchased, is also considered a Capital Expenditure, and not chargeable under the terms of this lease.
b. The original cost, depreciation or amortization of the Building or its contents or components, or the initial development of the Real Property;
c. Expenses for the preparation of space or other work which Landlord performs for any tenant or prospective tenant of the Building;
d. Expenses for repairs or other work caused by fire, windstorm or other insurable casualties;
e. Expenses incurred in leasing or obtaining new tenants or retaining existing tenants, such as, but not limited to, leasing commissions, advertising or promotion;
f. Legal and Accounting expenses incurred in enforcing the terms of any lease or incurred to protect the owner’s investment;
g. Interest, amortization or other costs associated with any mortgages, loans or any refinancing of the Building or land;
h. Expenses incurred for any necessary replacement that is under warranty;
i. Special electrical, heating or air conditioning required by any tenants that exceeds normal building standards whether or not reimbursed by such tenants;
j. Accounting and legal fees relating to ownership, construction, leasing, sale or litigation;
k. Any insurance expense incurred for other than building operations (i.e. rent insurance);
I. Any interest or penalty incurred by building management for the late payment of Building Operating Costs;
m. Any cost associated with the ownership of the Building, and not properly included as an operating cost of the Building;
n. Any Building Operating Costs for other rentable areas of the building to the extent Tenant pays for such expenses directly for Tenant’s rentable area;
o. Any cost representing an amount paid to a related corporation which is in excess of the amount which would be paid in the absence of such relationship;
p. The cost of correcting defects in the construction of the Building or in the Building equipment, except that conditions (not occasioned by construction defects) resulting from ordinary wear and tear shall not be deemed such defects;
q. Building Operating Costs shall be “net” only and for that purpose shall be reduced by the amounts of any reimbursement or credit received or receivable by Landlord with respect to an item of cost that is included in Building Operating Costs. After hours HVAC shall be considered reimbursements to Landlord for purposes of this clause;
r. The initial cost of tools and small equipment used in the operation, repair and maintenance of the Building;
s. Initial Cost of any landscaping or the regular landscaping maintenance of any additional property added subsequent to Tenant’s lease commencement;
t. Any penalty or fine incurred for non-compliance with applicable building or fire codes by Landlord or any other tenant;
u. Any ground rent;
v.The cost of compliance with any governmental regulations that are in effect as of the Lease Commencement date;
w. Damage and repairs necessitated by the negligence or willful misconduct of Landlord or Landlord’s employees;
x. Salaries for individuals beyond the level of building manager, and Landlord’s general overhead expenses not related to the Building;
y. Charitable or political contributions;
z. Costs incurred in connection with any portion of the Building which is used for commercial concessions, such as parking and for which parking fees are charged; and
aa. The acquisition or leasing costs of any sculptures, paintings or other original works of art and applicable insurance on the same, in excess of amounts typically spent for such items in office buildings of comparable quality in the competitive area of the Building;
bb. Rent on management office or value to landlord of management or other office space in building used to manage building;
cc. Bad debt loss, rent loss or reserves for either of them;
dd. Costs, expenses or expenditures relating to the duties, liabilities or obligations of other tenants in the building;
ee. Costs incurred by landlord arising out of its failure to perform or breach of any of its covenants, agreements, representations, warranties, guarantees or indemnities made under this Lease;
ff. Cost incurred in the removal, abatement or other treatment of asbestos or other hazardous substances present in the building or on the real property.
Right to Audit Landlord Records
The lease should allow tenant or its representative to audit the landlord’s records. If possible, the clause should not limit the time period in which the audit will be performed. A sample audit clause is attached for use as a reference.
Indexing of Rent
As an alternative to a complex operating expense clause, some landlords index their rents. This may seem like a simple and fair way to provide for rent escalations, but be wary; there are a variety of indexes, with many subtle variations in common use, and their behavior can vary substantially. Make sure you understand the implications of any index proposed as the basis for figuring your escalations, and always include a sample calculation of the escalation in your lease.
Both Landlord and Tenant need to recognize that there may be disputes about operating expense clauses and charges. This can mostly be alleviated by carefully written lease clauses. However, when disputes do arise, they often can be resolved amicably by utilizing the lease’s audit provisions. The Beinhaker Law Firm can assist with the lease drafting, as well exercising a Tenant’s rights pursuant to the lease’s audit provisions.
SAMPLE AUDIT SAMPLE AUDIT CLAUSE
Landlord agrees to maintain accurate books and records of the Operating Expenses incurred as well as Real Estate Taxes paid. Landlord agrees to keep such books and records and copies of or the actual paid bills for each year including the Base Year for the duration of the Lease term and for one (1) year thereafter. The Operating Expenses, including those for the Base Year, may be audited by Tenant or Tenant’s authorized representative during normal business hours, upon reasonable prior notice. If Tenant, in good faith, challenges Landlord’s computations of the Base Year Expenses or the amount of the Operating Expense Escalation or Real Estate Tax Escalation, Tenant shall notify Landlord in writing of its objections. Following receipt of such notice and during the pendency of the dispute, Tenant may withhold the amount in dispute by reducing the estimated monthly installments of Additional Rental then payable by Tenant by the amount in dispute, and Tenant shall not be in default hereunder by reason of such withholding. Tenant shall be required to pay so much of the amount so withheld as is determined to be due to Landlord, within thirty (30) days of resolution of such dispute.
Karen S. Wachs, Esq. is a partner at The Beinhaker Law Firm concentrating her practice in business representation, business transactions and commercial litigation. She has extensive experience handling leases and CAM charges for clients, as well as representing condominium associations and their members. If you have a question about a business topic, email Karen at firstname.lastname@example.org or call our office for a free consultation.