Leases: When Management Fees Are Not Enough

By Michael Pappas
Over the last few years, a disturbing trend has emerged in commercial real estate that is costing office tenants as much as $1.00 per square foot in additional rent obligations. Buried deep inside operating expense statements is a relatively new addition that a few but growing number of landlords are inserting into escalation billings. Corporate or general overhead expenses are now considered by many landlords to be a legitimate pass-through expense to tenants. This amount is in addition to landlords receiving reimbursement for on-site expenses plus a fee to manage the operations of the property.

Although some tenants attempted to address these issues in the past, most leases afford tenants little or no protection against the need to reimburse the landlord for these types of ambiguously defined allocations. What began as a trickle a few years back has become a flood.

Initial modest costs associated with on-site building management, office rent, and computer leases have expanded into extensive charges for off-site corporate overhead. They include salary allocations for personnel tangentially associated with the property in the areas of accounting, finance, lease administration, information technology, construction, and human resources functions. Additional allocations include rent, operating expenses, real estate taxes, payroll taxes, insurance, travel and entertainment, meals, and other occupancy expenses for the premises that house off-site personnel.

This methodology is particularly egregious for a tenant with a base-year lease that commenced before the new charges began to be imposed. Due to the lack of consistency between the base year and the current operating year, the tenant in effect is paying the full cost of these expenditures rather than only the increase above the base-year level.

Owner-Managed Properties
The new trend is almost exclusively associated with owner-managed properties, including real estate investment trusts (REITs). The related-party relationship inherent in the owner-managed property means an absence of market discipline and creates a potential conflict of interest. Alternatively, this situation is almost never encountered when an independent third party manages the property. This is somewhat paradoxical in that the management fee charged by independent third-party managers is often a fraction of the fee charged by owner-managers.

Several factors come into play with owner-managed properties to the detriment of the tenants. The management fee structure for owner-managed properties is typically based upon a percentage of revenues collected from tenants. The fee bears no relationship to the actual cost of providing management services. In a rising rental rate market, a tenant faces the prospect of substantial fee increases while receiving the same level of management services. In contrast, independent third-party management fees are often based upon a fixed rate per square foot and provide for inflationary increases over the term of the agreement. This results in a much less costly and more stable fee structure.

Additionally, all the corporate overhead charges of the independent management firm are absorbed by it as a component of the fee. This had always been the case until recently, even in owner-managed properties. The management fee charged was more than adequate to cover all indirect costs of providing management services (after direct costs are reimbursed by the property) and still provide the owner-manager with a reasonable profit. In today’s environment however, owners view their management fee as pure profit and therefore seek reimbursement of all overhead charges.

The question and issue for tenants is…what to do? Lease language that precludes such actions is certainly advantageous. But this provides no benefit for existing leases, nor is it the ultimate panacea for tenants. In these cases, a tenant’s best defense is to be proactive in reviewing the landlord’s underlying accounting records to flush out these hidden costs. Only then will a sense of fairness enter the equation.

Michael E. Pappas, CPA, is Senior Managing Director, Corporate Real Estate Services, in BDO Seidman’s New York office. He can be reached at (212) 885-8429.

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