Five Ways for Companies to Reduce Operating Expenses in Office Leases by guest author Don Travis
For most companies, the cost of rent for their office or industrial space is the second largest expense after the cost of compensating their workforce. While rents in Atlanta either have remained steady or in many cases have declined throughout the Great Recession, going forward, one component of rent, Operating Expenses, could be a major concern for Tenants as inflationary pressures begin to take hold in the economy.
Many office leases are "full-service" leases meaning that all Operating Expenses at the building such as those for utilities, property taxes/insurance, and common area maintenance are included in the rent. Tenants, however, are usually required to pay their pro-rata share of any increases in Operating Expenses over a Base Year which is typically the year in which the lease term commences. This increase in Operating Expenses which is borne by Tenants is commonly known as a "pass-through" of Operating Expenses.
Outlined below are five (5) ways that Tenants potentially could protect themselves in their lease against a sizable pass-through in Operating Expenses which can operate as a somewhat hidden increase in rent.
- Evaluate Base Year. Tenants should obtain from the Landlord a breakdown of Operating Expenses for the building for at least the past three (3) calendar years as well as a projection for the current year to understand the building's Operating Expense history. Operating Expenses traditionally increase year-over-year in step with the overall inflation in the economy.
While Landlords will generally establish the Base Year as the year in which the lease term commences, renewal agreements are often treated differently. Landlords may or may not readily agree to establish a new Base Year.
(a) Period of Rising Expenses. During a period of rising Operating Expenses, Tenants should negotiate for a new Base Year which would be the beginning of the renewal term. Obtaining the new Base Year would eliminate any existing pass-through of Operating Expenses that the Tenant would otherwise carry into the new lease term.
Moreover, if a Tenant executes a lease or lease renewal agreement in the 4th quarter of a given year, then that Tenant should negotiate for the Base Year to be the following year to delay by one (1) year the impact of any pass-through in Operating Expenses.
(b) Period of Declining Expenses. On the flip side, what if Operating Expenses have declined during the lease term? With some buildings, this has indeed occurred since the onset of the Great Recession as building valuations have declined precipitously which in turn has caused property taxes, one of the largest components of Operating Expenses, to decrease.
If this were the case, it would be beneficial for the Tenant entering into a renewal agreement to retain the existing Base Year in the current lease. For example, if Operating Expenses in 2008, the original Base Year, were $8.00 per square foot and were projected to decrease to $7.00 per square foot in 2011, the Tenant would be well-served to retain its existing Base Year since the original Base Year, 2008, would offer the higher expense figure going forward. This would minimize the possibility of Tenant encountering a pass-through of Operating Expenses during the renewal lease term.
- "Cap" on Operating Expenses. Tenants should seek to "cap" increases in Operating Expenses at a building to no more than four percent (4%) per annum. Landlords may counter that some Operating Expenses such as utilities and property taxes are "uncontrollable" meaning that these expenses are outside the control of the Landlord and should not be "capped." At a minimum, Tenants should "cap" increases in "controllable expenses" which should be defined to include all Operating Expenses except for utilities, property taxes, and property insurance.
- "Gross-Up" Operating Expenses. Some components of Operating Expenses such as utilities and janitorial expenses are highly "variable" in nature and are impacted by occupancy levels at the Building. Tenants should therefore insist that the Landlord "gross-up" Operating Expenses for the Base Year to the level that the Operating Expenses would be if the Building were operating at a 95% occupancy level. Otherwise, a Tenant at a Building with 20% occupancy could incur a sizable pass-through which is caused not by rising prices but instead by an increase in the occupancy level at the building.
- Operating Expense Exclusions. Tenants should negotiate a list of exclusions to Operating Expenses such as expenditures that are "capital" in nature. These capital expenditures could include a new roof or a building lobby renovation. This list of potential exclusions to Operating Expenses is too large to address here.
- Right-to-Audit. Tenants should negotiate in their lease agreement a Right-to-Audit Operating Expenses to ensure that the pass-through of Operating Expenses is calculated correctly.
In conclusion, Tenants could incur significant liability through a pass-through of Operating Expenses and should therefore take measures to protect themselves in their lease agreements.
This discussion of Operating Expenses is for discussion purposes only. Tenants should retain legal counsel to review their lease agreement and have their counsel draft the appropriate language to protect themselves in this area.
Don Travis is a Principal of Travis & Associates LLC, a commercial real estate brokerage firm which focuses on representing its tenant clients in securing office or industrial space. Mr. Travis holds a B.A degree in economics, summa cum laude, from Vanderbilt University, holds a J.D. degree from the University of Virginia Law School, and holds a M.B.A. degree from the University of Georgia Terry School of Business. Contact Don at: firstname.lastname@example.org