This post is the third in our series entitled “The ABCs of Commercial Real Estate Leases”. The series is meant to both provide an overview of commercial real estate lease fundamentals for those who are new to the industry, and serve as a helpful and credible resource for anyone seeking information on a specific lease-related topic. Today, we’re going to continue our discussion on Rent and Recoverable Expenses, which we started in our last post. Our first topic: Operating Expense Inclusions and Exclusions.
Operating Expense Inclusions and Exclusions
Operating expense inclusions and exclusions are very common in commercial real estate. Usually, a lease will explain what items make up Operating Expenses. Often it is very clear, and the lease will state, “Operating Expenses means all expenses to operate and maintain the Building . . . and include the following: . . .” with a section that follows listing the included items. The first question that needs to be answered is: are real estate taxes included in operating expenses or are they calculated separately? Combining real estate taxes with operating expenses when they should be separate can result in a loss of income for the landlord in a “Gross” lease, as the chart below demonstrates:
In the above example, the landlord is entitled to a larger reimbursement if expenses are separated, but the decision to separate or combine expenses is dictated by the lease language only. Other items that may be pulled out of operating expenses and calculated separately include management fees and utilities. Sometimes, a lease may specifically exclude an item and not bill it separately. Most of these exclusions contain an element of common sense and fairness. For example, a lease would state that the landlord cannot include tenant improvement costs or commissions in the operating expenses of the building. That is because when quoting a lease, the landlord recoups these costs as part of the quoted rental rates. These costs should not be covered by other building tenants. In contrast, some items are rarely excluded. These are standard expenses, such as janitorial costs, security costs or elevator expenses. Exclusions of standard operating expenses are rare, but are very important to watch for and make note of. They most often occur in leases for larger tenants who have more negotiating power
A List of Standard Operating Expense Exclusions
Below is a list of standard operating expense exclusions. It’s commonly understood in the industry that these items are not components of Operating Expenses passed on to tenants, and it’s usually not required that these items be noted in detail. Any excluded item beyond the scope of this list should be noted.
- Ground Rent
- Cost of capital improvements to the Building (including capital projects that are done for code compliance or to reduce expenses).
- Depreciation or amortization of any improvements.
- Salaries and employment expenses of personnel above the level of Building or General Manager or Asset Manager.
- Expenses of any leasing office incurred with regard to leasing the Building.
- Cost of operating and maintaining any specialty service, such as an observation deck, broadcasting and/or telecommunications facility, or luncheon, athletic or recreational club.
- Payments for rented equipment, the cost of which would have constituted an excluded capital expenditure if the equipment were purchased.
- Cost of acquiring or leasing paintings or other objects of art, including costs incurred in maintaining and insuring such objects.
- Costs expended to bring the Building into compliance with the ADA.
- Costs to cure violations of laws to the extent the Building is in violation of laws as of the Commencement Date, including any fines for such violations; provided LL may include in Operating Expenses the cost to cure violation of laws which occur after the Commencement Date.
- Asbestos, radon or other hazardous materials removal or encapsulation.
- Cost of future renovations to the Building.
- Lobby renovations.
- Advertising and promotional expenditures.
- Costs of legal, professional or consulting fees to the extent such costs are not reasonably intended to reduce Operating Expenses for the Building and to improve the quality of services to tenants.
- All expenses in connection with dues and/or subscriptions, travel expenses, entertainment expenses and recruitment and interview expenses.
- Costs of any disputes between any employee or agent of LL, or any mortgagees or ground lessors of LL.
- Mortgage principal and interest on building or land.
- Costs associated with leasing space in the building or relocating tenants.
- Charging back costs (other than deductible) for which LL received insurance proceeds.
- Late fees, fines, penalties and interest charged on past due accounts.
- Legal and auditing fees in connection with disputes with tenants. Legal fees and court costs other than those incurred in any dispute regarding application of governmental requirements to the general occupancy, maintenance and operating of the Building and costs and expenses incurred in connection with the enforcement of leases and occupancy agreements, including without limitations, attorney fees and disbursements.
- Costs of services paid to any affiliate of LL which are in excess of prevailing market costs for such services.
- Bad debt loss.
- Charitable contributions.
- Compensation paid to persons in commercial concessions operated by LL.
- Ownership expenses, tax preparation fees, LL’s financial statements and corporate minutes preparation.
- Cost of any special services rendered to a particular tenant or costs reimbursed to a tenant which services or costs are not generally rendered or reimbursed to other tenants.
- Costs to correct structural defects in the initial construction of the Building.
- Costs for performing additional services or installation to or for tenants to the extent such service is done without charge to tenants.
- Financing or refinancing costs.
- “Takeover Expenses” (i.e. Lease Buy‐Outs).
- Any amounts payable by LL by way of indemnity or for damages or which constitute a fine, interest or penalty, including interest or penalties for any late payment of marketing costs.
- The cost to LL in curing its defaults under the Lease to the extent such costs exceeds the normal cost of Operating Expenses.
Caps On Operating Expense Increases
Rather than excluding a particular component of operating expenses, as described in the previous section, it may be decided to cap the increases on that item, on the expenses as a whole or on just a portion of the expenses. By requesting a cap on controllable operating expense increases, a tenant can more easily predict the cost of the lease over the term. It will know that it won’t be placed in a precarious financial situation if controllable operating expenses increase beyond the norms.
Cumulative vs Annual Expense Caps
Caps on increases are either cumulative or annual. A cumulative cap compounds from year‐to‐year and usually, if the increase in one year does not meet the stated cap, the variance between the actual and the cap can be “saved” and applied to the following year. For example, if the cap is 5% and for a year the increase is only 4%, the increase for the following year can be as much as 6% without violating the cap language in the lease. An annual increase is one which resets each year. Using the prior example, the 2nd year increase cannot go up to 6%, but must remain at 5%.
Examples of Cumulative and Annual Expense Caps
The most important thing to know is how to identify whether or not a cap is cumulative or annual in the lease language. Here are some examples to help you tell the difference:
“Tenant’s Pro Rata Share of Controllable Expenses shall not increase by more than 6% over Tenant’s Pro Rata Share of Controllable Expenses in the previous calendar year, including the Base Year, on a cumulative, compounded basis.”
“In no event shall the total amount of Operating Expenses used for the calculation of pass‐throughs each year of this Lease after the Base Year (other than non‐controllable expenses such as, for example purposes only, real estate taxes, insurance and utilities) exceed 105% of the total amount of the prior year’s Operating Expenses, on a cumulative basis.”
“In no event shall the total amount of Operating Expenses used for the calculation of pass‐throughs to Tenant for each year of this Lease after the Base Year (other than real estate taxes, insurance, and utilities) exceed 106% of the total amount of Operating Expenses (other than real estate taxes, insurance, and utilities) passed through to Tenant for the immediately prior year.
Caps On A Single Expense
As seen in the examples above, oftentimes, caps do not apply to all expenses. Rather, they are more specifically defined. Rarely, a lease may cap one expense. For example:
- Management fees are capped at 3% of income.
- Capital amortization is capped at $5,000/annually.
- Amount of management office rent that a landlord can include as an operating expense is capped at an office of no more than 985 sq. ft. Most often though, you will see a cap applied to a group of expenses, most commonly referred to as “controllable” expenses. This language will acknowledge that some of the expenses related to operating a building are beyond the control of the landlord and that the landlord should not be left “holding the bag”, so to speak. These expenses often include (with the first three being most commonly excluded from controllable):
- Real Estate Taxes
- Unionized labor
- Snow removal
Any expenses deemed “non‐controllable” in a lease will be removed from the cap calculation. The tenant will pay the full amount of these expenses on a year‐to‐year basis, but all other expenses are subject to the cap calculation
Some Important Tips on Expense Caps
- Caps are not always based upon a percentage. Sometimes they are based on a flat dollar amount. For example, increases in operating expenses may be capped at $0.50/sq. ft. annually.
- A lease may state that tenant’s share of Operating Expenses for Year 2 are capped at $5,000/annually and Year 3 expenses are capped at $5,500/annually.
- A cap that is based on a percentage can also have “floor”. That is, annual increases in operating expenses may be no less than 2% but not more than 5%. The 2% would be the floor, the lowest percentage increase.
- Caps can also be based upon increases in CPI (Consumer Price Index) and these leases will contain extensive language on the index that will be used, the base index and the comparative index. CPI increases are likely to have an additional layering of a floor/ cap provision (i.e., no less than 2% no more than 5%)
Additional Rent and Recoverable Expense Concepts
Any thorough discussion on Additional Rent and Recoverable Expenses in commercial real estate leases should include three important and fundamental concepts:
Because all four topics are so essential to commercial real estate, and there’s a lot to say on each, we’ve devoted entire posts to each. To read a post and learn more about that topic, just click on the corresponding link above.
Questions About Commercial Real Estate Leases?
That wraps up our discussion on Rent and Recoverable Expenses. If you have any questions about anything you read, or about commercial real estate leases in general, feel free to email us at firstname.lastname@example.org.
If you’d like to learn more about commercial real estate leases, keeping checking the Realogic Blog for additional posts on the subject. We have many more planned for the weeks ahead. In addition, we offer a training class called Understanding Commercial Real Estate Leases that might interest you, as well as a class on lease abstracting.
By Terry Banike, Marketing Manager, Realogic