Operating Expenses - Part II
It is reconciliation and estimate season.
How much are you paying in additional rent?
Are you sure your landlord has billed the correct amount?
If you have not read Part 1, please click here to view the first article on this topic.
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Gross-Up: A provision that requires the Landlord to increase certain categories of building’s operating costs which vary with changes in occupancy
Cap: An annual limit on controllable operating expenses.
Non-Controllable Expenses: Ad velorem taxes, property insurance, utilities and ice/snow removal.
Controllable Expenses: Expenses that do not fall under any of the ‘Non-Controllable” categories.RSF : Rentable Square Foot
Pro-Rata Share: Tenant’s RSF divided by the Building’s total RSF
Operating Expenses: The combination of services and utilities, insurance and taxes provided by the Landlord
NNN: Triple-Net
TICAM: Taxes, Insurance and Common Area Maintenance
CAM: Common Area Maintenance
Base Year: The calculation of actual operating expenses incurred by he Landlord during the calendar year in which the Tenant’s lease commences
Pass Through: Actual expenses incurred, which exceed the Base Year stop amount, over subsequent calendar years in the lase.
A ‘Gross-Up” Can Level the Playing Field with the Landlord
To help level the playing field, a base year “gross-up” provision should be negotiated and included in the lease agreement. A “gross-up” provision requires the Landlord to increase certain categories of building’s operating costs which vary with changes in occupancy. With this adjustment by the Landlord, these variable costs, reflect what such costs would have been if the building was fully or almost fully occupied so the tenant is paying their “true” proportional share of the expenses. Utilities, such as electricity, are some of the most common expenses that are affected by occupancy and these variable costs can constitute as much as 40% of total operating expenses. Without the gross up, when the variable expenses increase because of increased occupancy, the Tenant is paying for a share of the variable expenses that is greater than their true proportional share.
See the differences in our Tenant’s Year 2 Operating Expenses (OPEX) with and without a Gross-Up provision in their lease when the Building’s occupancy increased from 50% to 100% between our Tenant’s Lease Year 1 and Lease Year 2.
Example 5
*If you extrapolate this amount annually on a 5-year lease, this equals $185,335 in additional rent to the Tenant over the course of the Lease.
Example 6
*Conversely, if you extrapolate this amount annually on a 5-year lease, this only equals $21,550 in additional rent to the Tenant. Savings of over $163,000 over the course of the Lease.
Are you protected against rising controllable expenses?
As outlined above, without a “gross-up” provision, a Tenant will have no protection against future excessive pass throughs. However, when “gross-up” provisions are present in a lease, the Landlord adjusts variable costs in the base year and in all comparison years to reflect a fully occupied building. This ensures the Tenant is protected in comparison years from large increases in operating costs due purely to increases in building occupancy, as seen above.
The “gross-up” provision is especially important in new construction. In new construction, where much of the space is unoccupied and buildings have not been fully assessed for tax purposes, expenses and taxes will be lower for the first year or so. If these expense figures (including taxes) are used as a guideline and not "grossed-up" to a 95% or 100% occupied building and fully assessed value, tenants will be saddled with a disproportionate share of the excess burden.
Even with a gross-up provision as protection in the lease for operating expenses, a Tenant still needs an annual “Cap” on operating expense increases. This “Cap” also serves as an important mechanism that requires the Landlord to better control its costs.
In addition to variable and non-variable operating expenses, Operating Expenses can also be broken down into “Controllable” and “Non-controllable” expenses. For simplicity, non-controllable expenses are typically defined as ad valorem taxes, property insurance, utilities and ice/snow removal. All other expenses generally fall under the controllable category.
Good real estate advisors negotiate, or encourage Tenants to negotiate, a “Cap” on the controllable operating expenses. Not only does this “Cap” ensure that Landlords control their costs, but it also helps a Tenant more accurately budget for a "not to exceed" amount for annual additional rent. We have secured large savings for our Clients by negotiating a “Cap” on controllable operating expenses; in certain instances, savings in excess of $100,000.
Example #7
We hope this helps you understand the importance of reviewing these reconciliations and ensuring they match your Lease document. You can feel confident that you are paying an appropriate amount of Additional Rent or you may find savings for your company. Please reach out if you have any additional questions in regard to your operating expenses, existing lease or the market.
