Operating Expenses
It is reconciliation and estimate season.
How much are you paying in additional rent?
Are you sure your landlord has billed the correct amount?
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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.
When it comes to Operating Expenses in a Lease Negotiation, there is a lot that can significantly impact the amount that the Tenant ultimately ends up paying in Additional Rent. For a busy business professional, it may be difficult to find time to comb through your lease to look for your correct pro-rata share, your base year, a gross up and/or cap on controllable operating expenses. Additionally, if no one has ever explained how these real estate terms affect your bottom line, you may not prioritize this task. Below we introduce these topics and the importance of each. If you have any questions or would like further information, please contact us by clicking the link below or at the bottom of the article.
In most multi-tenant office buildings, tenants pay a base rental amount and a pro-rata share of expenses incurred by the Landlord to operate the building. The Tenant’s Pro-Rata Share of expenses, which should be defined in the Lease Document, is simply the Tenant’s Rentable Square Footage (RSF) divided by the Building’s total RSF. So, if a Tenant occupies 10,000 RSF, and the Building has a total of 100,000 RSF, the Tenant’s Pro-Rata share would be ten percent (10%).
Example 1
For the Building to operate efficiently and be a desirable place for Tenants to conduct business, the Landlord must also provide services (i.e. janitorial, maintenance, utilities, landscaping, etc.) that come at a cost. Additionally, Landlords incur insurance premiums for property, casualty & liability coverage, along with municipal and county ad valorem taxes. This combination of provided services and utilities, insurance and taxes are commonly and collectively referred to as “Operating Expenses”.
Let’s assume a full-service rental amount of $30.00/RSF ($30.00 per rentable square foot), with a $10.00/RSF of the $30.00/RSF attributable to Operating Expenses. The other $20.00 is generally referred to as the “Net” rental rate, the rate exclusive of the Operating Expenses, Taxes, and Insurance.
If your lease is not a full-service lease, you may encounter the following terms:
“Triple-Net” (NNN) lease, “Taxes, Insurance and Common Area Maintenance” (TICAM), and “Common Area Maintenance” (CAM), which sometimes are used interchangeably with the term Operating Expenses.
Example #2 - Full-Service Rental Rate/RSF Breakdown
Operating Expenses and Base Year
While often defined differently between Landlords and Tenants, the “Base Year” is, essentially, the calculation of actual operating expenses incurred by the Landlord during the calendar year in which the Tenant’s lease commences. In the example above, the $10.00/RSF allocation toward operating expenses would be known as the “Base Year”. It serves as a “stop” amount, allowing the Landlord to “pass through” to the Tenant, actual expenses incurred, which exceed the Base Year stop amount, over subsequent calendar years in the lease. Many factors can contribute to annual increases in operating expenses including inflation and increases or reductions in building services.
For our purposes, the Landlord assumes a 5% increase in Operating expenses. In our example, the actual, operating expenses for the first calendar year of the lease were $10/RSF and this amount was included in the Full-Service Rental Rate. With the assumed 5% increase in Operating Expenses, the annualized Estimated Operating Expenses for the second calendar year of the lease will be $10.50/RSF. Remember, the Tenant has a defined Base Year as specified in the Lease, with the $10/RSF included in the Full-Service Rental Rate. However, the Landlord will “Pass Through” the additional $0.50/RSF to tenant as “Additional Rent”. This is an important concept as the pass-through amount typically increases every year of the lease. Below you will see the Pass-Through Calculation and how it is applied to the Rental Rate.
Example #3a - Operating Expense/RSF Pass Through Calculation
Example #3b - Operating Expense/RSF Pass Through Calculation
The importance of reviewing a Tenant’s annual Base Year Operating Expense Reconciliation, provided by the Landlord, cannot be emphasized enough. It is critical to ensure the methodology follows the lease agreement and that the billed amount is accurate. We have found many errors over the years where the Base Year alone was not calculated correctly, resulting in improper, and in certain cases, egregious, Additional Rent charges to our Clients.
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.
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 - No Gross-Up Provision (Building Occupancy Increased from 50% t0 100%)
Example #5b - Additional Rent to Tenant in Year 2
*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 #6a - 100% Gross-Up Provision in Lease (Building Occupancy Increased from 50% to 100%)
Example #6b - Additional Rent to Tenant in Year 2
*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 #7a - No Cap on OPEX
Example #7b - 5% Cap on Controllable OPEX
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.
