Operating Expense Escalations Explained

In the early part of every year, tenants in many commercial buildings will get their "operating expense escalation" bills.  In the past, this was a very predictable 2-3% over the previous year, but today, with rising utility costs and insurance, operating escalations are anything but predictable. Tenants need to know what constitutes their operating expenses and how they can minimize the impact on their rent and occupancy costs.

Simply put, operating expenses are the total cost of all the goods and services needed to keep a commercial property running.  Among them are the costs for utilities, heating, air conditioning, water, trash removal, landscaping, snow removal, janitorial expenses, security, insurance, accounting, management fees, repairs and maintenance or other costs associated directly with the operation of the property.  Real Estate taxes are generally calculated separately, but methods for "passing through" escalations are similar.

When a tenant signs a lease, operating expenses are handled on either a gross or net basis.  In a gross lease, the operating expenses are included in the rent and the landlord pays the expenses throughout the year; in net leases, the tenant must contract directly with all the services it needs to operate the property and pay the bills directly.  There are also hybrid leases such as partial net, or partial gross, but essentially the methodology for calculating escalations are the same, but not all of the items in the operating budget are either included or excluded.  In this post, I am going to focus on the "full service" gross lease , where everything is paid by the landlord and how escalations are handled.

When a tenant signs a new "full service", gross lease, generally in an office building, and the rent is negotiated, part of the rent is net to the landlord and is used to pay his debt service and/or profit, and part is used to pay the operating expenses and real estate taxes for the building.  Let's say the rent is $20.00 PSF (per square foot) of which $5.00 is for operating expenses and $2.00 is for real estate taxes.  So, the landlord is netting $13.00 a foot.  In the following year, the taxes increase to $3.00 and the operating expenses increase to $7.00 PSF.  Consequently, without similarly increasing the cost to the tenant, the landlord's net rent would decrease to $10.00 PSF.  To avoid the erosion of the landlord's net rent, most leases have an "Operating Expense and Tax Escalation Clause", which establishes the base cost of the expenses and taxes when the tenant first leases the space ( the "Base Year") and allows the landlord to "pass through" any increased costs each year during the lease term. 

At the end of each year, the owner reviews his bills for the preceding year, calculates the cost and if it has exceeded the amount allocated in the tenant's base year rent, he increases the rent for the next year by that amount.  In the example above, that would be an increase of $3.00 a foot, and the rent the tenant pays would increase to $23.00 a foot for the next year.  Subsequent lease years would repeat this calculation and increases would be passed through accordingly so the landlord's profit of $13.00 a foot stays constant every year of the tenant's lease.

It would appear that tenants have no control over how much operating expenses increase, but that is not always the case.  There are some simple things a tenant can do to avoid excessive operating expense escalation costs.

• When signing a new lease, the tenant needs to examine the "Base Year" used.  Make sure the base year specified in the lease is actually your first year of occupancy.  For instance, let's say you signed a lease in December of 2007, and the lease specified a base year of 2007.  Using the example above, that means that in January of 2008, a mere one month after occupancy, your rent would increase by $3.00.  In this case, it would not be unreasonable for the tenant to ask for a base year of 2008, then any increases would not occur until 2009. 
• Compare operating expenses of different buildings under consideration.  Buildings with similar rents in similar locations should have similar operating expenses.  When you have narrowed your search down to a couple of buildings, ask for the operating expense statements of the buildings your are considering.  Buildings with significantly higher operating expenses should be examined carefully.  Most costs are fixed and outside the owner's control, such as electricity, gas, trash removal, but some costs are discretionary, such as management fees, and should be a red flag if they are excessively high compared to other buildings
• Examine what items are included in the operating expense budget. Be wary of leases that include "capital costs" as part of the operating expenses.  Capital costs are expenses for replacing big items such as new HVAC units, or new roofs, windows, sidewalks, etc. These should not be included in ordinary operating expenses. 
• Know when a tax reassessment is occurring.  Many municipalities reassess buildings on a regular schedule.  Be careful if you are signing a lease close to a reassessment period, the taxes could increase considerably upon reassessment. 
• Try to have your lease contain an audit provision. This may be hard to accomplish for a very small tenant in a large building, but if you occupy a large portion of a building, you should have the right to examine the operating expenses of a building if you believe the operating expense escalation is abnormally high.  Determine what rights you have to challenge costs that seem excessive.
• Choosing the right landlord is important.  Experience owners know how to negotiate contracts and get the best prices.  Your broker should be able to assist you in selecting landlords who have solid reputations and have been in business for a long time.  You can also do a little investigation on your own by calling another tenant in the building and asking them how they like it in the building and have they been treated fairly.  Very few new tenants think about this, but you may be surprised by what you hear from either a happy or unhappy tenant in the building. 

In the final analysis, as a tenant, you cannot avoid operating expense escalations, but by avoiding some of common mistakes and pitfalls, you can at least avoid any surprises in the first year of your occupancy.  For new businesses, operating on a limited budget, the first year of business is most crucial, so averting costly mistakes can mean the difference between success and failure.

You will find more tips and strategies for negotiating commercial leases on MySquareFeet; the premier commercial real estate listing service where owners and brokers post available space and tenants connect directly to the leasing agent

Comments

[Garrett]

Operating expenses and Base Year pass throughs are tough to plan for and really can take a big bite out of your budget. If you want to see how some small businesses struggle to find space before they even have to face operating expenses, check this video out:

www.rofo.com/video

[Garrett]

Operating expenses and Base Year pass throughs are tough to plan for and really can take a big bite out of your budget. If you want to see how some small businesses struggle to find space before they even have to face operating expenses, check this video out:

www.rofo.com/video

[Vancouver realtor]

What I found particularly interesting was the info about the info about the landlord. As a reltor I have a specific view on rented buildigs,Vancouver real estate ,in particular. But I have to say that sometimes I cannot give my clients any more specific information about the landlords. There's always something to improve.