Negotiating Operating Expenses in Commercial Leasesby Ashley Wong | August 22, 2019
For many companies, a commercial lease is one of the most critical and high-value contracts into which they’ll ever enter. While the average commercial lease term is between 3 to 5 years, these leases can run up to 10 years, plus extension periods. Unlike most other contracts that a business might sign, a commercial lease often doesn’t provide the ability to terminate mid-term, unless a material breach of the agreement occurs. All this to say that, whether you are the Landlord or the Tenant, you want to get this right.
In commercial leases, the rent structure is typically made up of two parts: Base Rent and Additional Rent. Typically, “Base Rent” is easily calculated as the price per square foot paid by the tenant during the term of the lease, while “Additional Rent” is a catch-all bucket for any amounts paid by the tenant under the lease in addition to the base rent. One of the largest categories within Additional Rent is “Operating Expenses.”
What are Operating Expenses in a Commercial Lease?
Operating expenses are costs associated with operating and maintaining the property, and it’s critical that both landlords and tenants understand how Operating Expenses are calculated. Otherwise, tenants risk paying much more under the lease than anticipated and landlords risk a shortfall in covering the expenses required to operate the building. When negotiating provisions that affect the calculation and payment of Operating Expenses, Landlords should consider how any modifications may impact the calculation of Operating Expenses concerning the other tenants in the building. Tenants typically each pay their pro-rata share of the total cost based on the percentage of rentable square footage they occupy in the building. For example, a tenant leasing a 100 square foot space in a building with 1000 total rentable square feet would pay 10% of the building’s Operating Expenses. This can be especially complex in a mixed-use building (i.e. the nature of the tenants varies – residential, commercial, industrial, retail), as different lease structures may be used for different types of tenants.
Commercial leases will often devote multiple pages to the calculation of Operating Expenses and will typically include a laundry list of items that the landlord can pass through to its tenants. Some examples of items that might be included in Operating Expenses are: employee payroll and benefits for property managers, administrative, and other personnel; office supplies; legal fees; costs for repairs and maintenance of exterior and interior common areas, including, for instance, parking lots, lobbies, landscaping, sidewalks, walls, flooring, and roof; costs for repairs and maintenance of building systems, such as electrical, plumbing, and HVAC systems; advertising costs; administrative, accounting, professional and other costs associated with general management of the building; employee uniforms; janitorial services; improvements; security; and furniture and other décor.
Landlords should be careful to ensure that all necessary costs and expenses are provided for in this section and should include a catch-all for all other costs deemed necessary and appropriate by the landlord for operating and maintaining the property.
Tenants, on the other hand, should consider what costs should be excluded from this calculation. Some examples of exclusions include: works of art, costs incurred by landlord as a result of a breach of the lease or violation of law; costs associated with preparing space for any tenant of the building; political or charitable donations; any amounts paid to landlord affiliates in excess of what would be charged in an arms-length transaction; costs associated with operating a parking garage or other specialty area (such as a fitness center, retail space, or cafeteria) for which the landlord already charges a fee; and any costs reimbursable by insurance.
How Lease Structure Impacts Operating Expenses
The first question when reviewing any lease – How is this lease structured? The answer to this question will determine whether Operating Expenses need to be negotiated at all. Because every commercial lease is different, the terms used to describe these structures are often inconsistent. When it comes to lease structures, there are two extremes: On the one hand, a full-service gross lease, in which the landlord bears all the risk and reward associated with the variability of Operating Expenses, and on the other hand, an absolute net lease, in which the tenant(s) bear all the risk and reward associated with the variability of Operating Expenses.
- Full-Service Gross – In a full-service gross lease, the tenant pays base rent, which is inclusive of all Operating Expenses, including property taxes, insurance, utilities, in-suite janitorial, and Common Area Maintenance (CAM). Full-service gross leases are more straightforward but can result in a tenant paying higher rates, as the landlord bears the risk of any significant increases in Operating Expenses. With a true full-service gross lease, Operating Expenses don’t need to be negotiated because the tenant’s rent is entirely fixed.
- Absolute Net Lease – In an absolute net lease, the tenant pays a lower base rent plus its share of all Operating Expenses. While an absolute net lease lacks the certainty for tenants that a full-service gross lease offers, both landlords and tenants can benefit from this lease structure. For landlords, all of the risks of increased Operating Expenses is shifted to the tenant. Tenants, on the other hand, can benefit from overall lower rent, if negotiated and managed carefully.
- Other Lease Structures – Operating Expenses will be passed through to the tenant to some extent in each of the following lease structures.
- Net Lease (Single, Double, and Triple Net, often abbreviated as N, NN, and NNN, respectively) – Under a net lease, tenant pays base rent plus one or more of the three “nets”: (i) property tax, (ii) insurance, and (iii) CAM.
- Modified Gross Lease – This term is used variably and inconsistently across the industry. Technically, all of the net leases are modified gross leases, but this term may also be used to refer to gross leases that exclude other items, like in-suite janitorial or utilities.
- Base Year – Many gross or modified gross leases will be structured as “base year” leases, which means that the tenant only pays base rent during the first calendar year or lease year, and thereafter, the tenant pays its share of Operating Expenses to the extent they exceed the base year operating expenses.
Key Provisions to Negotiate
- Gross Up Clauses – Gross-up provisions are commonly found in commercial leases. Put simply, a gross-up clause allows a landlord to calculate Operating Expenses owed by a tenant as if the building were fully occupied (typically, a lease will specify between 90-100% occupancy), when in fact the building occupancy was lower on average during the calendar year in question. For landlords, gross-up provisions can be a critical tool to mitigate the risk of coming up short on Operating Expenses due to an under-occupied building. Tenants may be concerned that a gross-up clause will result in significant increases in rent. However, when properly drafted, a gross-up clause should result in a more equitable breakdown of Operating Expenses between tenant and landlord. The following are a few key considerations for tenants when reviewing a lease that contains a gross-up provision:
- To which types of expenses does the gross-up provision apply? For instance, it might make sense to include electricity, janitorial, utilities, and trash removal, as these costs vary based on occupancy. However, it might not make sense to include fixed costs, such as taxes and insurance. Other items may be subject to negotiation, such as building security. Lastly, the tenant should ensure that it is not responsible for any amounts in excess of the landlord’s actual costs for the included expenses.
- How is the tenant’s pro-rata share calculated? Typically, this is a fairly straightforward calculation, with the numerator being the tenant’s rentable square footage and the denominator being the total rentable square footage of the building. However, some leases will exclude from the denominator any unoccupied space, which could have a significant impact on the calculation of tenant’s pro-rata share.
- What is the gross-up percentage? Gross-up percentages are most often between 90-100%. If landlord and tenant are unable to agree on the inclusion of a gross-up provision or what expenses are included, a lower gross-up percentage may be a reasonable compromise.
- CAM Cap – Another helpful negotiating tool is the CAM cap. A “CAM cap” is an agreed cap on the amount that a tenant’s share of common area maintenance charges may increase from year to year, typically expressed as a percentage between 3% – 6%. CAM caps are commonly used with base year leases and are an easy way for tenants to shift the risk of a significant increase in Operating Expenses back to the landlord and incentivizes the landlord to be efficient with its spending. Landlords may have many reasons for agreeing to include a CAM cap in a lease – often it’s necessary to come to an agreement with a desirable and savvy tenant. In such cases, landlords should consider who, then, is responsible for covering any amounts that exceed the cap with respect to that tenant. If other tenant leases do not permit the landlord to pass through these types of un-covered costs, then the landlord will be responsible for covering the difference. The following are important items for each party, especially the landlord, to consider when negotiating a CAM cap:
- Controllable vs. Uncontrollable. Landlords should ensure that the CAM cap provision excludes uncontrollable expenses, including real estate taxes and assessments, insurance, and utilities. Other more surprising, but potentially necessary, exclusions include snow removal and security expenses.
- Cumulative vs. Non-cumulative. The lease should state whether the cap is cumulative or non-cumulative. Cumulative caps benefit landlords, as the cap increases by that percentage year-over-year, regardless of the actual CAM costs each year. Non-cumulative, on the other hand, means that the cap can only increase by the identified percentage over the amount actually paid by the tenant in the prior year. This one word can result in significant financial impact for both landlord and tenant.
- Audit rights – In addition to negotiating how Operating Expenses are calculated, tenants should consider asking for the ability to review the landlord’s books and records concerning the Operating Expense calculation in order to ensure that the landlord has complied with what was negotiated in the lease. If a tenant requires audit rights, landlords should require: (i) that the tenant exercise these rights within a certain timeframe after receipt of the final Operating Expense calculation each year, (ii) that the tenant pay for the costs of the audit, unless it shows that the landlord has overcharged by more than 5% (or some other agreed amount), and (iii) that the audit must be performed during regular business hours and in such a way as to not interfere with the regular business operations. Finally, the landlord may also want to require approval rights of the firm that performs the audit or even specify a firm or class of firm (i.e. a “big 4” accounting firm) to ensure that the audit is performed by competent, unbiased professionals.
Commercial Leases: Don’t Ignore the Small Print
Needless to say, commercial leases can be incredibly complex creatures that are difficult to negotiate and draft properly. Both building owners and tenants have a lot on the line, even hidden in contract language that’s often overlooked. But you don’t have to go it alone. Contact Equinox and one of our attorneys can assist you in negotiating, or simply understanding, the terms in your commercial lease.