Operating Expenses and Your Lease – The Golden Opportunity to Maximize Savings (Part 1)

Don’t Let Rental Rates and Landlord Concessions in your lease negotiations lull you to sleep.

Did I get your attention? Good. You know, then, that negotiating on your rental rate and landlord concessions are clearly important elements of any lease, but a common mistake that tenants and ineffective brokers make is over-focusing on those terms and practically ignoring other lease clauses that – if not negotiated effectively – will end up costing the tenant tens or hundreds of thousands, or even more, over the life of the lease.

A key provision which many brokers tend to under-emphasize, and landlords too often succeed in turning into an additional profit center, is the definition and treatment of operating expenses. If poorly negotiated, this section of the lease can make a landlord richer while crippling a tenant slowly over time. For this reason, terms dealing with operating expense calculations and definitions are the number one money saving clauses to negotiate aggressively besides your rent or concessions.

In this two-part series, we will focus contextually on Base Year Office leases, but much can also apply to Office NNN leases and even some Industrial NNN leases. This writing is not intended to be exhaustive or comprehensive and should not be relied upon as legal advice or even real estate advice for your specific situation. As always, I encourage you to engage a vetted “tenant-only” broker from a “tenant-only” firm and an experienced real estate attorney as part of your real estate team prior to engaging in the process leading to a lease transaction of any kind. This writing is more technical than my usual, and starts with defining operating expenses, so buckle up… let’s go!

Operating Expense Definition

This is where the rubber meets the road. When the landlord is calculating operating expenses, this portion of the lease will dictate what is and isn’t allowed in the calculation, and will be relied upon should a dispute arise. This language should be thorough, concise, and clear.

What should be included and excluded in Operating Expenses?

This topic alone could be covered in several blogs, and the purpose of this writing is to highlight some of the biggies and to alert you to the importance of hiring a good broker and real estate attorney to help negotiate legal and market-appropriate terms when it comes to these provisions in your lease.  Therefore, this list is not intended to be exhaustive, but will simply highlight some of the more important items. Please also keep in mind that there are items that are acceptable operating expenses in one region that may not be in another. For example, snow and ice removal in Phoenix is not an acceptable operating expense, while it most certainly is in Chicago.

Generally, the operating expense definition should include items which are appropriately associated with the cost of operating the office building; this could include the real estate taxes, utilities, insurance, management, maintenance, repair of the building, project, and premises. The following are a few examples of what should be excluded from the operating expense definition in a lease (consult with your tenant broker for a complete overview):

• Tenants should exclude the cost of Capital Improvements, Capital Expenditures, Capital Repairs, and Structural changes made to the building or property. Assuming these repairs, improvements, expenditures or structural changes are original to the building and in the mortgage, the benefits of those capital improvements will benefit the landlord far beyond the expiration of the lease and tenants do not have an equity position in the property (generally).  There are a few common exceptions and caveats to this exclusion that are generally accepted that we will not delve into here, but your tenant broker can walk you through in detail.
• Depreciation and Amortization Charges for the Property and for Capital Equipment – In a typical scenario, if the landlord were to pass these items through to the tenant as an operating expense it would be an unreasonable profit center because the landlord should be depreciating these costs annually as a taxable expense, and these costs should already be covered by the rent collected by the landlord.
• Corporate Overhead/Executive Salaries – This one can be tricky to properly define because of some of the grey areas that occur with landlords that are performing their own supervision and management of the property – which can be a huge and sometimes unreasonable profit center. The key is to focus on excluding expenses that are related to the operation of the landlord’s business or businesses, versus the operation of the building or project. Including language that limits management expenses is also advisable.
• Advertising/Promotional expenses for the Project, Building or Premises – Much like the above exclusion, this is a cost a landlord incurs in attracting revenue, not the cost of operating a building.
• Leasing Commissions and Related Expenses – This is the cost of doing business as a landlord and clearly should not be passed on to the tenant as an operating expense. Primarily, it should already be underwritten into the rent and would be double dipping.

Now that you understand a little more about how operating expenses are defined in your commercial lease, in part 2 of the series we’ll look at the different types of operating cost lease structures. Stay tuned!

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