Originally posted by our Exis Partner Darius Green of Keyser
This is part 2 of a 2-part series on Operating Expenses within a lease negotiation. In part 1 of the series, we discussed defining “operating expenses” and a small sample of items which should be excluded from your lease operating expense definition.
Now that you know the importance of negotiating the definition of operating expenses in your commercial lease, let’s take a deeper dive into how those same operating expenses can be structured into your lease.
STRUCTURE
In commercial leasing there are three basic types of operating cost lease structures:
Industrial Triple Net (NNN) – Tenant is responsible for, and contracts directly with, vendors for any and all building services needed. Theoretically, the landlord should not have any building operating costs to pass through to the tenant; however, there are many Industrial Triple Net leases that occur in industrial parks with common areas that incur operating costs and must be maintained along with association fees. Therefore, even in industrial leases it is important to negotiate common area maintenance (“CAM”) and operating cost provisions carefully.
Full Service Gross – In a true full service gross lease the landlord contracts with and pays directly all of the vendors for building services and includes those costs (pro rata share for each tenant) in the base rent that is collected from the tenants without any separate charge (e.g. operating cost escalations) to the tenant. Because the landlord is assuming all the risk of rising costs for the operation and maintenance of the building, true full service gross leases are a rarity.
Modified Gross – Landlord passes “operating costs” through to the tenant for reimbursement of fees for which the landlord has contracted directly with, and paid vendors for, building services. Typically, a tenant is billed separately for its share of building operating costs in addition to base rent. There are several types of the modified gross lease: Base Year, Expense Stop, Stipulated Base Amount, and Office Triple Net.
A Base Year Lease establishes a baseline of operating expenses for the tenant. The landlord and tenant agree that the total operating expenses in the “base year,” as defined by the lease, will establish the baseline value or contribution for which the landlord would be responsible. Typically, this is the first calendar year of the lease term but can be defined as another annual period. The tenant is responsible for the pro-rata share of operating expenses that exceed those expenses incurred in the base year in the subsequent comparison years. A tenant’s pro rata share is the rentable square feet of the tenant’s Premises divided by the rentable square feet of the Building/Project. Outside of the previously mentioned full service lease, this is generally the most tenant-friendly structure in office leasing.
“Gross-Up” concept
Building operating expenses can fluctuate depending on levels of vacancy which change from time to time over a lease term, especially if a tenant is in a building with high vacancy. To protect the tenant from wild swings in operating expense costs, a gross-up provision allows the landlord to equitably project costs as if the building was consistently occupied [typically 95% to 100% occupied depending on the market]. This provides the tenant cost certainty and when variable expenses are grossed up during the tenant’s base year, it prevents the landlord from adding more variable operating expenses in subsequent years when the building is fully occupied. This concept is also applicable in expense stop, stipulated base amount, or an office NNN lease.
Expense Stop Leases establish for the tenant a fixed dollar amount that represents what the landlord is responsible for contributing to operating expenses. This dollar amount is expressed in terms of dollars per rentable square foot which serves as an offset against the actual building costs in a given year. The tenant is responsible for the pro rata share of any excess that occurs after subtracting the expense stop amount from the actual operating costs.
Stipulated Base Amount Leases are very similar to expense stop leases with the main difference being that the stipulated base amount is expressed as a whole dollar amount instead of a dollars-per-rentable square foot, making it not subject to issues that can arise from rounding.
Office Triple Net (NNN) Leases allow the landlord to contract and pay for building services (unlike industrial NNN), and then pass those costs through to the tenant for reimbursement without any expense offset to the tenant starting from lease commencement. Unfortunately for the tenant, this structure is becoming increasingly popular with office landlords across the market at large.
Cumulative vs Compound Caps
Real estate taxes, insurance, snow removal (where appropriate) and utilities are non-controllable expenses in an office building; everything else is controllable. Tenants with leverage should be negotiating on an annual cap to make sure controllable costs don’t get out of hand from year to year, holding the landlord accountable in managing their operating expenses.
There are inconsistencies industry wide as to how caps are applied and usually those inconsistencies are driven by incorrect language on leases which the landlord produces. No matter the type of cap, they can be distinguished by whether they are calculated over the prior year, or from the first year of the lease (base amount). Generally, there are two types of caps: cumulative and compound.
Cumulative caps always reference the initial base period when the additive value of the cap is multiplied. Here is an example of a cumulative cap calculation formula at 4% over 4 years:
Year 1: Base Amount
Year 2: Base Amount x [1+4%]
Year 3: Base Amount x [1+(4%+4%)]
Year 4: Base Amount x [1+(4%+4%+4%)]
Compound caps reference the previous year’s value when multiplied to calculate the next year’s cap (if it is calculated from the base amount, it must be stated explicitly in the lease). Here is an example of compound cap calculation (over the prior year) formulas at 4% over 4 years:
Year 1: Base Amount
Year 2: Base Amount x [1+4%]
Year 3: “Lesser Of” x [1+4%]
Year 4: “Lesser Of” x [1+4%]
(“Lesser Of” is the lower of the prior year’s actual expense or the expense cap amount)
The advantage of the compound cap when calculated over the previous year is that if and when expenses either don’t increase, or increase less than the cap, the tenant saves money.
No matter what type of cap is negotiated we highly recommend examples using hypothetical numbers are included in the lease language to mitigate any confusion or misinterpretation when referenced later.
These are the major structuring terms for operating expense calculations; they are vitally important as they set the formula for the tenant’s operating expenses during the entire term of the lease. Do not underestimate the level of difficulty to obtain optimal terms with certain landlords on the structure; a good tenant-only broker can help you achieve optimal results.
Understanding how operating expenses are defined and how they can be structured into a lease is vitally important, so now that you know that and have negotiated appropriate terms with your team – how do implement and enforce this aspect of your lease?
IMPLEMENTATION/ENFORCEMENT
Audit Rights
Of what good is negotiating an awesome lease, with tenant-friendly operating expense language, if the tenant does not hold the landlord accountable to the lease language during the term of the lease?
Having the ability to audit the landlord’s books and records is extremely important. In our experience, out of 10 leases for which we do a preliminary review, 7 to 8 have billing issues and of those, 2 to 4 have enough issues to warrant auditing the landlord’s books and records.
I can’t underscore enough the importance of annual preliminary reviews to see if an audit is warranted, especially for larger tenants where realized savings from mistakes made by the landlord can be in the six- and even seven-figure range over the life of the lease – much more significant than that extra month of abated rent you might be overly focused on in a lease negotiation.
In conclusion, let’s do a quick review: excluding base rent and other explicitly financial landlord concessions to the tenant, operating expense structure, definitions, and implementation thereof financially impact the tenant more than virtually any other section of an office lease. If tenants don’t negotiate and exercise rights to conduct annual preliminary reviews to determine if a full audit is necessary, they are likely throwing money away and/or wasting the cost, time and energy of their team that negotiated optimal operating expense terms.