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Leases: Reviewing Annual Operating Expense Statements
by Martha Meli
By this time, most commercial tenants with pass-through costs in their leases have received from their landlords the annual Operating Expense Reconciliation Statement. Typically prepared mid-year for the prior calendar year, the statement reflects the tenant's obligation to pay its share of increases in the total occupancy costs of the building, often the second highest expense after payroll.
Tenants today accept the idea that increasing costs constantly chip away at the landlord's profit margin that was carefully calculated into the basic rent set when the lease was executed. In order to preserve the profit margin, landlords expect the building tenants to absorb increased costs of operating the building due to higher property taxes and a higher level of services. Notwithstanding their awareness of the escalation clause in their leases, tenants often are taken by surprise when the statement shows expenses much higher than anticipated. The question that invariably comes to mind is whether increases have been properly calculated and whether some costs have been improperly included. At the very minimum, the tenant should take out the lease and compare the cost items in the reconciliation statement with the language of the operating escalation clause.
Allowed and Disallowed Items
Most office leases contain a laundry list of items for which the landlord may charge tenants, along with a list of disallowed items. Some leases describe operating expenses in more general terms. In either case, the annual statement can contain items for which tenants clearly are not obligated to pay as well as items that could be interpreted either as operating expenses or another type of expense - a capital expenditure, for example, or an expense unrelated to the operation of the building.
Some costs that should be checked carefully by the tenant include the following:
- Salaries: The landlord may include salaries paid to all of its personnel, including cleaning and security staff, managing agent, executives and other staff members. The tenant, on the other hand, will not wish to pay the salaries of the landlord's staff (or the landlord's own salary), since these are not directly attributable to the tenant's occupancy of space. Usually, only the salaries of the managing agent and his subordinates are included in operating expenses; higher-ups are excluded. Further, when an outside management firm is used, its fees should approximate those paid by comparable buildings in the neighborhood.
- Expenses for leasing space in the building: The landlord may seek to include expenses such as advertising and promotion incurred to obtain new tenants, as well as brokerage commissions and legal and administrative expenses relating to negotiating new leases or enforcing the terms of existing leases. A tenant may argue that such expenses bear no relationship to the space the particular tenant leases in the building.
- Overtime charges: Typically a tenant using its space outside of normal business hours must reimburse the landlord for the overtime costs of HVAC (heating, ventilation, and air conditioning) and sometimes for the costs of a security guard or freight elevator. Such costs always should be excluded from the escalation charges, otherwise the landlord will be twice reimbursed.
- Capital expenditures: An operating expense clause in a lease should be very specific in distinguishing repairs and improvements from capital expenditures. Operating expenses customarily include repairs to the common areas of the building as well as to core building systems such as elevators, HVAC, lighting fixtures, wiring, security systems and sprinkler systems. On the other hand, the normal replacement of core systems, or costs incurred to correct structural, design or engineering defects should properly be regarded as capital outlays that are the responsibility of the landlord. When an expenditure is for the purpose of modernizing a building system that will reduce operating expenses in the future, the tenant's position should be that such costs can be treated as operating expenses only if the tenant will share in future savings resulting from the improvement. One way to do this is to provide that the annual expense pass-through relating to the improvement will not exceed the amount of the annual cost savings to the tenant.
- Outlays required by law: During the lease term, new laws or regulations may require unanticipated capital outlays. For example, a new law may require the installation of equipment to improve air quality, or require the removal of asbestos or the purchase of new safety equipment. The tenant may argue that such capital costs are one of the risks of property ownership and in addition, increase the value of the building. If the tenants are required to pay such costs, the annual pass-through should be based on the useful life of the new equipment.
- Other charges: Other charges sometimes included in an operating expense reconciliation statement that should be challenged by the tenant (unless clearly authorized by the terms of the lease) include: expenses for which the landlord has been or will be reimbursed by a third party; rent payments under a ground lease; the landlord's routine corporate and administrative overhead; debt service on a mortgage or any loan, fees or penalties; and any loss of value due to any form of depreciation, including normal wear and tear, functional depreciation and social and economic depreciation.
Grossing Up Base Year Expenses
Equally as important as analyzing the expenses included in operating costs are those that may be omitted, especially in your base year. A tenant expects that it is paying rent for a fully operational and fully serviced building. If the tenant's base year was one of the years when the building was leasing-up, a later year may show an unusual increase in the expense escalation. If expenses in the base year were not adjusted to reflect costs that would have been incurred for a fully occupied building, the tenant may be paying more than he should. Rather than reimbursing the landlord for increases in costs due to inflation, the tenant pays for the added costs associated with having more tenants in occupancy (more area to clean, more trash, etc.) The landlord may even charge a higher management fee for serving more tenants. To avoid this, the escalation clause should provide that expenses in the base year(s) should be "grossed up" to reflect normal occupancy levels.
Self-Protection
Very often a tenant takes great pains to negotiate its operating expense clause, making sure that the list of inclusions and exclusions are specific to its needs and that it contains proper gross-up language. The landlord or its managing agent may not review each tenant's lease before preparing the annual escalation billing. What complicates this further is turnover of owners and managing agents after a sale of a building, or even the natural internal turnover of an owner's accounting staff. Tenants can protect themselves from paying more than their fair share of expenses by retaining auditors whose sole purpose is to review the specific calculation of an operating expense escalation.
Martha Meli, RPA, is a Director in the Corporate Real Estate Services Group in BDO Seidman's Woodbridge, N.J., office. She can be reached at (732) 734-1002.
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