Have you ever received a bill from your landlord claiming that you owe them for base year escalations? Most likely you have. Every tenant that rents space under a multi-year gross lease incurs a base year escalation, but not everyone remembers agreeing to it. Some tenants aren’t even familiar with the term!
Believe it or not, there is almost certainly language in your lease about base year escalations. Even if you missed it, you’re still on the hook to pay for it. This blog will help you understand where these expenses come from and how to plan for them.
A gross lease consists of base rent and operating expenses. The base rent is a fixed number that the landlord has predetermined based on their investment(s) into the building. The operating expenses are created on what’s commonly known as a base year. If you signed your lease in 2015, then your base year is 2015. Your operating expenses are adjusted based upon the expenses in the base year and you agree to pay a pro rata share above and beyond the base year in the future.
Here’s an example. Your rent is $20 PSF which consists of $12 PSF in base rent and $8 PSF in operating expenses (because operating expenses in 2015 were $8 PSF). If operating expenses increase in 2016 to $8.25 PSF then you’re subject to pay the additional $0.25 PSF. If in 2017 your operating expenses jump to $8.50 PSF then you’ll need to pay an additional $0.50 PSF. This comes as a surprise to some tenants and for some, it can cause a major disruption to their bottom line.
You’re probably thinking: “How, exactly, do I account for these expenses without a crystal ball?” The answer: Make an educated guess. It’s not possible to know exactly how much your operating expenses will escalate because we can’t predict increases in real estate taxes, just as we can’t predict the weather (two large components of operating expenses). However, we can look back at a three-year history to gauge how much operating expenses have increased year-over-year.
So before you sign your lease, ask your broker to request a three year history of the operating expenses from the landlord. And just to be safe, make sure your lease consists of language which gives you the right to request an audit of the operating expenses. A good rule of thumb is to set aside an additional 2-3% of your current year’s operating expenses for next year’s escalation of operating expenses.
Let’s be crystal clear about annual rent escalations: They are not the same thing as base year escalations. If your rent is $20 PSF in year one and you’ve agreed to pay $0.50 PSF annual increases then your rent will be $20.50 PSF in year two. That means you should account for both rent escalations and base year escalations. Here’s a tip of the trade: You can renegotiate both when you renew your lease.
The information contained herein has been obtained from sources deemed reliable. While every reasonable effort has been made to ensure its accuracy, we cannot guarantee it. No responsibility is assumed for any inaccuracies. Readers are encouraged to consult their professional advisors prior to acting on any of the material contained in this report.