Every manager's nightmare is the huge, unbudgeted, unanticipated invoice. Yet managers everywhere face the same problem - operating expense pass throughs. While rent continues to be the most obvious financial aspect of any lease, there are little known gremlins of economic surprise hidden behind rent. On full service or gross leases, the quoted base rent per sq. ft. is actually a combination of two forms of rent. The largest is the capital portion from which the building owner pays the debt service and generates profit. The remainder is the operating expense portion which covers normal expenses associated with the operation of a standard office building.These reflect such fixed expenses as taxes and insurance and such variable expenses as utilities, janitorial service, consumable supplies, maintenance and repairs, etc.
In some markets or in certain buildings, different items such as real estate taxes or utilities may be separated out in the lease document for special handling or direct billing to the tenant (a form of net lease). However for the purpose of ease, whether in or separate from the operating expense language, the premise is the same.
The operating expense portion of the rent rises as the cost of services increases. This increase is passed through to the tenant as additional rent. This is usually billed annually and the tenant must immediately pay the lump sum increase PLUS be billed monthly for the anticipated increase for the upcoming year.
Most leases contain “STOP” provisions wherein the tenant begins to reimburse the landlord to pay for increases after the expenses exceed a specific number that is ordinarily determined under one of two structures, "Base Year" or "Base Amount". In either structure, a basis number is determined and above which the tenant is obligated to pay. The Base Year concept usually considers that the operating expenses as totaled in the first lease year of the tenant’s occupancy becomes the base amount over which the landlord will charge the tenant.The Base Amount structure simply makes the declaration of the operating expense amount up front in the lease.
This is very good for the owner and investors who have pushed any increases off of their books and onto the tenant. These terms can also be just as negotiated by the tenant during the lease negotiations as any other lease term.
Would it not be absolutely wonderful for manufacturers, service providers, insurance companies and others to have the pre-established right that if it costs more to provide the service or product, you simply bill the client? The real estate owners are the one group which historically has enjoyed the privilege of knowing what they will spend and to avoid any deterioration of the return on investment, simply pass increases through to the tenants. If Boeing tried that on the U. S. Navy, it is doubtful that they would sell many jets. The owner does put up a plausible argument though, that these are consumable items by the tenant and therefore billable to the tenant, not carte blanche services in exchange for the rent. In deed, some of that argument holds water, but just because that argument holds water it does not mean you should shy away from the negotiations to improve your position. The tenant does have recourse, but only before the lease is signed as part of their leverage in negotiations; never after.
As an example to explain how the tenant gets billed for operating expenses, let's assume a full service rental of $20.00 per sq. ft. The operating expenses may be only $6.00 per sq. ft. which leaves $14.00 per sq. ft. for the owner to pay its debt and hopefully earn a return on its investment. After operating expenses reach $6.00 per sq. ft., the landlord’s amount has stopped and the tenant starts paying any amount above it. Any amount above the $6.00 is the tenant's responsibility. The impact of these pass throughs can be significant. For example, an increase of just 50 cents per sq. ft. on a 10,000 sq. ft. lease will cost the tenant $25,000 over a five year lease term. 50 cents may only be 2.5% increase on the $20.00 per sq. ft. rent and viewed by some as rather insignificant, but how many more widgets or how much more service do you need to sell to your clients and customers to earn a net $25,000 to make up for an unanticipated $25,000 cost outlay? I hope this is starting to sink in. Can you imagine a pass through based on the increase in the cost of living of, say 5%? $50,000! Or worse, no cap or ceiling on how high the increase can go. And no motivation on the part of the Landlord to keep operating cost in line when they can just bill the tenants for any increases?
The "Base Year" structure of operating expenses is generally the safest to the tenant in that the base amount over which the tenant will be charged is based on actual operating expenses for either the previous calendar year or "Fiscal Year" of operations. Assuming the building has been operated ordinarily and with reasonable occupancy, the tenant will usually get billed the adjustment amount and the landlord's good faith projected estimate of the upcoming annual increase billed monthly in advance. Two caveats to this structure are 1) that the expenses are not increased due to the increased occupancy of the building, and 2) Selecting the right Base Year is important when you are commencing a lease late in the calendar or "Base" year. This would allow the Landlord to bill you an increase much sooner. In these cases, a base year should be established as next year.
The Operating Expense "Base Amount", sometimes knows as the “Expense Stop” is functionally different in that a specific expense is stated up front and at the time the expenses rise above that amount, the tenant gets billed. The caveats for this structure are both the increased occupancy of the building and that a real expense amount is used as a basis.
FEEL RUN OVER?
LANDLORD MISCHIEF WITH OPERATING EXPENSES
Building owners, forced to compete in the marketplace by showing a lower rental, may quote lower operating expense numbers than actual. By doing this, the landlord can hold their property up to the market looking as if the rent is lower than competitive buildings. Let's take our $20.00 per sq. ft. again, lower the "stop" to $4.75 and the owner can advertise space for $18.75 per sq. ft. without cutting his capital portion (where he makes his profit). The downside to the tenant will be that by using an artificially low base operating expense number and when the actual expenses are determined to be quite a bit higher, the tenant will be faced with an unbudgeted increase in rent. If the tenant fails to pay this increase, it could be put in default of the lease. Even if the default is cured, the default may have voided certain benefits the tenant may have had such as renewal or expansion options.
A broker was called upon to help a tenant who suffered just such a fate. Their 5,000 sq. ft. leased clearly stated $5.00 per sq. ft. for operating expenses as part of a $15.00 per sq. ft. full service rental rate. Remember, any increase above $5.00 per sq. ft. would simply be billed to the tenant. Barely one year after occupancy, whamo, the operating expense bill arrived stating the operating expenses had been determined to be $7.00 per sq. ft. A $2.00 per sq. ft. hit immediately or $10,000, and subsequent increases from this during the remainder of the lease were calculated to total over $20,000 to the tenant. In many circumstances, a landlord that knowingly misquotes the operating expense may be liable for misrepresentation, and in some cases, fraud. A worthwhile consideration, if you do suspect just such monkey business, is to contact all other tenants in the building, especially those that are larger and have more to loose. Without accusing the landlord of misrepresentation which could be libelous itself, simply indicate what has happened to you and seek to determine if something similar has occurred to them. Advise them what your intentions would be if it were proven that there was a problem (you would seek recourse by not paying the increase, put the Landlord in default and seek damages including the cost of performing such a review.Courts could also be sought for injunctive relief). A collective dispute from more than one tenant will have a profound effect on the solving the problem.
A medium sized advertising and production firm leased 4,500 sq. ft. The rental had been negotiated successfully with the condition that the owner provides evidence that the operating expenses being quoted at the time of the lease were fair and accurate estimates of the actual costs. The landlord brushed over this giving general assurances that never would they treat a "good client" by overcharging. Eighteen months later, the “good client" tenant got a bill for $9.750. The landlord knowingly misrepresented the operating expense base year amount of $4.75 per sq. ft. when in reality the actual operating expense amount was $6.25 per sq. ft. Balance due $1.50 per sq. ft. ($6,750) plus the estimated monthly amount of next years expense increase of $3,000. "DUE ON RECEIPT" Needless to say, this tenant flipped out, and justifiably so. Had the Tenant required the landlord warrant that the operating expenses of $4.75 per sq. ft. were fair and accurate, there would have been recourse.
One step further is to create a remedy for you if you find such abuses. A remedy can include offsetting rent or escrowing any disputed amount until resolved and without default to your lease. The provisions for doing this must be in the lease first.However, if it is not in the lease, escrowing the disputed amount in a bank with a receipt of its deposit to the landlord will usually suffice until the dispute can be resolved. Submitting it to a court as trustee until it can be persuasive especially if the landlord did knowingly misquote rent.
Language should be included in the lease to provide that the tenant may withhold paying a disputed amount or escrow an amount without being in default of the lease. One of the oldest tricks in the book is to send out large operating expenses and then follow up saying that non-payment of the expense will put the tenant in breech of the lease. Faced with fighting their landlord over an amount which may not be worth hiring an attorney to defend, many tenants simply acquiesce. As Winston Churchill said, "Never! Never! Never!". Never allow the landlord this ability on operating expenses or any other term of the lease.
To affirm that these types of financial unpleasentries do not occur, plan to provide for a Lease Audit, each year if necessary.
Demand that the operating expenses of the building be provided by having the landlord complete an operating Expense Breakdown form. During the building search period, the form is an excellent tool to smoke out possible abuses up front. Using the BOMA (Building Owners and Managers Association) or the Institute of Real Estate Management (IREM) Operating Expense books which monitor most all cities operating expenses, you, or your agent, can quickly and easily determine whether the quoted expenses are within reason.
Once a building is selected, the form should be attached to the lease as an Exhibit whereby the landlord warrants and represents that the stated amounts are fair and accurate.
