Projecting rent expenses is one of the largest concerns of the tenants while negotiating lease agreements. Reasonable tenants would not want to “handcuff” their landlords in order to allow them to attract new customers and operate building effectively. But at the same time tenants would wish to control unanticipated rent escalation and skyrocketing financial liabilities as well as to minimize their exposure to surprising, improper and unreasonably increased invoices.
However, despite being aware of the necessity to accurately formulate rent provisions, it turns out that when it comes to negotiation many tenants become convinced that fixing base rent amounts and mere statement/mention of tenants’ responsibility to pay their shares in operating expenses are sufficient to determine the tenant’s scope of financial obligations toward landlord. Tenants assume that taking time to carefully and thoroughly revise operating expenses clause is needless and burdensome, and that it may affect tenant-landlord relationships and preclude the deal from moving forward. Nevertheless, it makes sense for tenants to be mindful of the fact that the true rent amount and rent escalation are actually “hidden” in the operating expenses clause rather than in the base rent provision since operating expense definition is often so broadly drafted as to capture all possible costs far beyond operating and repair expenses. For this reason, operating expenses clause is usually referred to as “pass-through clause” meaning that landlords pass through their operating expenses to tenants. Given this reality, tenants would better be equipped with powerful and practical knowledge and tools to get operating expenses clause plainly drafted. Here you will find some of them.
Do You Homework
Before you start negotiating the lease, first, understand real estate market in the area where premises are located. In particular, be cognizant of lease structures that are commonly practiced in this area: gross lease, net lease, triple net lease, modified gross lease. Second, try to determine, if possible, who are the other tenants, if multiple tenant lease, what are their lease conditions, how much did they pay for the operating expenses during previous years, whether there were any rent escalations and whether they had to pay some unanticipated expenses. Third, scrutinize managing history of the building itself to be aware of actual costs and compare these amounts to similar properties and other buildings of the landlord, if any; for this purpose you may ask landlord to present you statements of operating expenses and real estate taxes for previous years. Finally, analyze real estate project to find out what operating expenses items would be worth negotiating.
When you start negotiating the lease, tell your landlord that you need to anticipate costs to prepare an accurate budget and to control downside risk from unanticipated liabilities. Hence, prior to outline terms sheet and letter of intent, make great efforts not only to fix base rent amounts but also to clearly determine what operating expenses consist of.
Narrow Operating Expenses Definition
Try to limit the definition of operating expenses to only customary, actual, reasonable, necessary and substantiated expenses and costs, obtained at competitive prices that are attributable to the repair, maintenance and operation, but not ownership, of the common areas of the building where premises are located. Words “common areas” are key words here because landlords tend to pass repair and maintenance costs related to the operation of the whole building. Besides, make sure that the term “common areas” is expressly defined in the lease and is exclusive of roof, exterior walls and foundations because they do not constitute actual common areas as well as of any leasable areas and areas not for common use and that do not benefit all the tenants.
While defining operating expenses, landlords naturally leave the definition unrestricted by adding the word “including” at the end of the sentence that automatically opens a door to a non-exhaustive list of all unimaginable expenses that one day may become a hard financial burden for the tenant. In addition, such limitless list may be strengthened by the “catch-all” list item providing that operating expenses include “other costs reasonably necessary to operate, repair, manage, and maintain the building where tenant’s premises are located”. To avoid unexpected results, whenever possible, try to obtain landlord’s consent to “close” the list by specifically and unambiguously enumerating possible operating expenses. Negotiating such concession would be rather difficult, sometimes impossible, since the landlord or landlord’s lawyer will argue that life is permanently changing and unpredictable and, hence, it is impossible to predict all possible costs and expenses. Nonetheless, you may try to highlight that the operating expenses list is already so all-inclusive and broad and covers a considerable number of costs to the extent that leaving this list open would create an unreasonable financial risk and potential hardship for the tenant.
One of the major difficulties involves the term “replacement” that tenants tend to remove from the operating expenses definition but that landlords insist upon keeping. Landlord may tell you: “Look, light bulbs are a good example of “replacement” equipment, and traditionally their replacement is paid by tenants. So, excluding “replacement” from the definition of operating expenses would mean that landlord would have to pay for bulbs and other similar things.” However, tenant may counter argue landlord by giving an example of LED and CFL bulbs that are more expensive than incandescent bulbs but which lifespan can go up to 20 years with a ten year warranty. Paying for these bulbs could be considered as landlord’s investment that usually exceeds the lease term, thus, replacement expenses are landlord’s costs of business. Alternatively, if landlord resists removing the word “replacement” from the operating expenses definition, tenant may add to the exclusion list “capital improvements and repairs attributable to, and replacement of structural elements of the building (roof, exterior walls and foundations)”, therefore, tenant will avoid paying replacement of capital nature equipment.
Broad the List of Exclusions
When it comes to the items included in the list of operating expenses, tenant should take time to consider each item, one by one, and delete operating expenses that were unreasonably passed through to the tenant by using the criterion of whether such operating expenses constitute ownership costs or not. However, taking into account that landlords are usually unwelcomed to remove provisions from their drafts, tenant may make its best efforts to set forth or broad the list of the costs excluded from the operating expenses reimbursed by tenant.
1/ Capital expenditures
To exclude capital expenditures (costs of capital improvements, capital repairs, capital replacements, capital equipment and capital tools) from the operating expenses tenant, first, could possibly argue that capital expenditures are expenses of ownership representing investments in the building that will far outrun the length of the lease. Second, tenant might point out that the base rent factors in most capital expenditures, i.e. base rent amounts were calculated as to cover the full depreciation of landlord’s investments. Thus, paying for capital expenditures will constitute a duplicative payment by tenant. Exception is commonly made to repair, not replacement, costs of HVAC, sprinklers and elevators that are usually paid by tenant.
Alternatively, if landlord insists on keeping capital expenditures in the list of operating expenses, tenant may limit the wording to the depreciation of capital expenditures amortized over a specified period of time or the useful life of the equipment, determined under generally accepted accounting principles, or to the depreciation of the items expressly named in the lease, like renovating storage space, updating wiring, repaving driveways and parking lots. In case if tenant accepts to pay the repair costs of capital expenditures, tenant may also specify that such expenditures will not occur more than once during the lease term.
Another compromise position to include capital expenditures that contribute to reducing operating expenses into operating expenses list is to spell out that such capital expenses should be included to the extent that such improvements actually reduce operating expenses of the building, or to the extent of actual savings achieved by such costs of capital nature.
Furthermore, you may expressly indicate in the lease that the costs of the acquisition of the property and the construction of the building and parking structures related to the building, whether initially or in connection with any replacement or expansion, as well as costs incurred by landlord for structural repairs, major repairs to building system (electrical, security, communications and others) are excluded from operating expenses.
2/ Management fees
Including management/administrative fees (i.e. costs of operating the building) into operating expenses is usually heavily negotiated item. Some specialists consider that management fees are a gray area of pass-through expenses and shall be excluded from operating expenses list since they create a potential for landlord’s abuse.
If landlord does not accept to remove management fees from operating expenses, tenant, first, should ask landlord to establish the manner in which “management fees” are defined. For instance, tenant might make management fees be contingent upon the total amount of operating expenses (even better of “controllable operating expenses”). Or, management fees could be based on rental income from such tenant’s premises that would be more cost cutting for tenant than management fees based on the rental income generated by all the premises in the building. However, if management fees are contingent on gross income generated by the whole property, tenant should be sure that the term “gross income” is defined in the lease and that it excludes any set-offs (like electric expense set-offs made by landlord in favor of certain tenants).
Second, tenant might limit management fees by establishing a cap equal to 3-15 %. Keep in mind that if tenant’s premises are located in single-tenant building, management fees may be pre-determined in advance and should be on the low side of the scale.
Furthermore, indicate that management fees shall not be more than those charged but other landlords of comparable buildings in the same area.
3/ Employee Labor Costs
Passing through operating costs to tenants, landlord may require tenants to compensate:
“wages, salaries, fees and other compensation and benefits; including payroll taxes, vacation, holiday, sick days, and other paid absences; and welfare, retirement, and other fringe benefits; that is paid to employees, independent contractors, or agents of landlord engaged in the operation, repair, management, or maintenance of the building.”
The tenant should be mindful of the salary compensation do not double management fees; for this purpose it makes sense to ask your landlord to draw a straight forward distinction between these two categories. Besides, tenant may want not to reimburse such salary compensation to positions higher than building manager, and specify that such compensation will be limited to employees, independent contractors and agents that are directly and on full time basis engaged in the management of the building.
4/ “Green” provisions
Given the increasing interest in complying with building sustainability ratings (e.g., the U.S. Green Building Council’s Leadership in Energy and Environmental Design (“LEED”), the Green Building Initiative’s Green Globes system) and other environment compliance standards, landlord and tenant are vested in tough negotiation of “green” provisions. While from the landlord’s perspective maintaining its property in compliance with sustainability ratings would easily attract more high-quality tenants who are ready to pay higher rents compared to the lease in “non-green” buildings, tenant is primarily interested in that such green provisions would result in cost savings and draw more high-quality customers.
To have “green” provisions plainly tailored, tenant, first, might limit “green” operating expenses only to those that lead to actual cost savings by tenant (e.g., installation of energy-efficient LED light bulbs) and, hence, ask landlord to annually provide supporting evidence proving the exact amount of cost reduction as a part of the landlord’s annual statement. Second, while accepting to reimburse landlord’s costs of reporting, managing and compliance with respect to sustainability rating and standards, tenant might refuse to compensate expenses of obtaining initial certification (including initial reporting and commissioning) or converting existing “non-green” building into “green” building. Third, tenant might ensure that his scope of additional “green” obligations (such as turning off lights at the end of the work day, sorting, separating and recycling of trash, water efficiency etc.) does not exceed that of other tenants in the building, and that landlord’s reciprocal green covenants are also expressly set forth in the lease (such as recycling programs for the whole building, energy and water efficiency in the common areas etc.).
Secure Your Right to Audit and Obtain a Statement
The lease should guarantee tenant’s rights to obtain a detailed and itemized statement of actual operating expenses with supporting documentation within a specified period following calendar year (between 30-90 days). Tenant may require such statements be certified by an accountant, especially, if accounting fees are included in operating expenses. However, be ready that landlord might be reluctant to make statement be certified by a CPA, and may insist on preparing such statements by himself or by his officer.
Make sure that if it turns out that the amount of estimated operating expenses exceeds the actual amount of operating expenses paid by landlord, you have the right to get your overpayment refunded. Sometimes, as an alternative, landlord may include an option to apply any overpayment to next rent payment due by tenant.
Additionally, tenant may wish to specify that that any operating expenses not included in the landlord’s statement are waived at the time the landlord’s delivers the statement to tenant or within a set period of time. This would limit the landlord’s ability to later pass through to tenant any additional operating expenses that the landlord omitted.
To examine the statement for accuracy, tenant should have the right to inspect the landlord’s books and records and to set forth objections thereof, if any. Tenant might try to make sure that he has at least three months to review and challenge the statement provided, however, that landlord made books and records available to tenant, at reasonable time and at reasonable locations, during such three month period. Otherwise, it would not be very efficient for the tenant to challenge the statement without having access to the landlord’s books and records. Moreover, tenant should be aware that if he does not dispute the statement of operating expenses within a certain period of time, he will be deemed to have accepted it, and thus, waived the right to dispute it.
Furthermore, tenant should clarify his right to have his examination costs reimbursed by landlord in case if operating expenses are overstated by 3-5%.
Finally, right to obtain a reconciliation statement of operating expenses and audit rights would better be included in the bulk of negotiation given that these rights are crucial and critical to enforce the operating expenses clause.
Operating expenses provisions are often overlooked by tenants at the stage of lease negotiations, and tenants may not be aware of any financial risks until they receive increased rent bills. This article gives an idea of how hard tenants should be focused on scrutinizing and clarifying operating expenses list before signing their lease. Otherwise, once the lease is signed, it would be difficult for the tenant to challenge the operating expenses reconciliation statement. Negotiation ideas proposed in this article do not cover other useful techniques, like establishing a “cap” on operating expenses escalation, or introducing a “most-favored nation approach” (meaning that tenant shall pay no more than other tenants in the building), or proving that landlord cannot collect more than 100% of operating expenses actually paid by him. This is to tell that tenant might come up with various creative techniques and arguments to narrow the operating expenses laundry list and mitigate the possible consequences of unexpected results.