Operating expenses in the office lease
Lease agreements for a typical office building are complex contracts, and most commercial leases provide a mechanism for common area maintenance and other building operating expenses — such as janitorial services, taxes and insurance — to be passed on to the tenant.
In office building leases, where separate utility metering is uncommon, utilities are also included in the pass-through of expenses. These pass-throughs are often referred to as “additional rent.” Most office tenants recognize the concept of the building owners’ charging rent for the building operating expenses, but the language contained in the lease can be confusing, subjective in interpretation and filled with substantial financial exposure.
One of three types additional rent provisions are commonly used by landlords to recoup the operating expenses of the office building in a commercial lease agreement:
1. Expense Stop: In this type of lease structure, a stated amount per square foot is designated as the operating expense component built into the rent. This number is commonly called the “expense stop.” The tenant is then required to pay its pro-rata share of operating expenses in excess of the designated “expense stop” amount.
2. Base Year: In this type of lease, a calendar year (typically the year the lease is signed or the preceding year) is designated as the “base year.” The tenant will be required to pay it pro-rata share of operating expenses in excess of the operating expenses for the base year.
3. Net Lease: Under this approach, there is no “stop” or base year. Rather, the tenant is required to pay its pro-rata share of the actual operating expenses incurred during each lease year.
Operating expenses are typically estimated by the landlord in advance and are payable by the tenant on a monthly basis along with the base rent. An annual settlement is generally called for with 90 to 120 days after the end of each year.
Most landlord lease forms broadly define operating expenses. A tenant, however, will want certain specified items to be excluded from operating expense calculations. In some cases, depending on the tenant’s negotiation leverage, the landlord will allow a cap or ceiling on “controllable” operating expenses. Expense items that landlords typically consider not controllable are taxes, insurance and utilities. These provisions also contain a clause giving the tenant the right to audit and challenge the landlord’s operating expense calculations.
Many landlords will include a “gross-up” clause in the lease. A gross-up clause allows a landlord to calculate operating expenses as if the building were fully occupied even though the building is not fully leased. The purpose of the clause is to allocate all variable operating expenses to the occupied space. For example, if a building is 50 percent leased, and variable operating expenses are $100,000, the tenants will pay only their pro rata share (50 percent). And thus the landlord will recoup only $100,000 of the actual variable expenses. A gross-up clause will allow the landlord to calculate the variable expenses as if the building were fully leased (that is, grossing up the expenses to $200,000) — such that the tenants will pay $100,000, the landlord’s actual cost.
The issues facing a tenant in connection with a gross-up clause are, first, to prevent the gross-up calculation from including non-variable costs such as taxes and insurance premiums, and, second, to be sure that the base year or expense stop calculations were made on a consistent basis (i.e., grossed-up if the landlord is using a gross-up clause).
A tenant rep and real estate attorney is needed
The “operating expense/additional rent” provision is just one of the many examples of tricky and sometimes confusing provisions contained in a commercial office lease. A poorly negotiated lease agreement can cost a tenant a significant amount of money over the term of an office lease. This is why every tenant should have both a competent a broker who specializes in representing tenants as well as a real estate attorney to assist in negotiating lease agreements. These professionals will work together to insure your risk is mitigated.
Coy Davidson is Senior Vice President of Colliers International in Houston. He publishes The Tenant Advisor blog.