The Dreaded Annual Operating Expense Statement

by CoyDavidson on January 22, 2010

This is the time of year that most office tenants begin to receive the building’s operating expense escalation statement for the previous year of their lease term. This is the additional rent charged to the tenant to cover the incease in operating expenses for the building. Even if the operating expense escalation has been carefully negotiated in the lease document, tenants are often surprised at the amount when the bill arrives.

Additional Rent-Operating Expense Obligations

Most office leases have additional fees they require a tenant to pay beyond the base rental fee. The landlord wants his tenants to pay their prorated share for some or all of the operating expenses to run the property effectively. Most office leases also contain a laundry list of items for which the landlord may charge tenants, along with a list of disallowed items.

Definition of Operating Expenses

Operating Expenses are the charges the landlord incurs to operate, manage, maintain, repair, and secure the property and its buildings. Your lease should define what is included in operating expenses. However, many leases at least in the original draft, does not go into specific detail as to what is defined as an operating expense. Most lease documents prior to negotiation of revisions rely on only a few general “catch all” descriptions to define operating expenses.

Example of Typical Lease Language

“Operating Expense” means any and all costs, expense and disbursements of every kind which Landlord incurs, pays or becomes obligated to pay during any Lease year in connection with the ownership, operation, maintenance, repair, replacement, and security of the building or the Land or the related appurtenances, including the cost of providing Building Services..

  • Wages, salaries and other costs of retaining the employees directly engaged in the operating, maintenance, repair, replacement and security of the Building;
  • All supplies and materials used in the operating, maintenance, repair, replacement, and security of the Building;
  • The cost of all utilities supplied to the Building, including gas, water and electricity;
  • The cost of management, maintenance and service agreements with third parties, including agreements for security, alarm service and elevator maintenance for the Building;
  • The cost of casualty and liability insurance applicable to the Building; and
  • all ad valorem taxes and assessments on the Land and any other taxes attributable to the Building or its operation and all costs (including consulting fees, but such fees shall never exceed the amount of any tax reduction realized) incurred by Landlord to evaluate and/or contest such ad valorem or other taxes

Most leases will further define a few typical items that will be specifically defined as not to be considered an operating expense. These typically include:

  • Leasing Commissions and Marketing Fees
  • Legal and Professional fees associated with leasing space or drafting lease agreements.
  • Build-out or leasehold improvement costs

An experienced tenant representative and tenant legal counsel will not accept this general and ambiguous language in the lease document and most reasonable landlords expect the tenant’s advisors to negotiate the language regarding operating expenses and rent escalations tied to increases in operating expenses.

The sample language above was taken from a lease document actually presented to one of my clients. General language like this without further negotiation leaves much open to determination by the Landlord as to determining operating expenses. For example, management fees by the building owner constitute an operating expense. However, a good broker will negotiate a cap on the management fee consistent with the marketplace. Let’s assume market rate management fee is 3% of the gross rental revenue of the property. In the language provided above the Landlord could charge a management fee in excess of market fees.

Depending on market conditions and the tenant’s negotiation leverage it is sometime possible to negotiate a cap or ceiling on operating expenses. If a landlord is to agree to this concession, they typically will only do so on operating expenses that are in their direct control. They will want to exclude operating expenses that are non-controllable (i.e. taxes, utilities and insurance).

A prudent tenant or his advisors pays special attention to the method of calculation for determining the tenant’s share of operating expenses (the expense stop, base year or stated, as well as gross up provisions)  in the lease document. They also should require the lease to specifically define what is to be included in operating expenses as well as specifically define items or costs that will be excluded from operating expenses. Below is a list of suggested items that can often be added to the lease document that will protect the tenants’ interest by clearly defining what should be excluded from the calculation of operating expenses.

Operating Expense Exclusions

Audit Rights: The charges for operating expenses can be significant. Accordingly, the tenant should have the right to audit (inspect or examine) the Landlord’s records related to such expenses.

Whether intentionally or not, landlords often miscalculate operating costs, rent escalations and other charges and end up overcharging tenants under their leases.  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.

I have had several clients over the years receive incorrect escalation statements. The most recent case, my client’s statement was calculated using the wrong base year. I am comfortable the new owner made an honest mistake by not picking up the  fact the a new base year expense stop was negotiated with the most recent lease renewal and they had used the base year expense stop from the original lease prior to renewal as the basis for calculating the tenant’s bill.  In this particular instance a formal lease audit was not required and the landlord corrected the bill promptly as we brought the error to their attention.  As a standard practice I ask my clients to forward their operating statements for review. However, had they just paid the bill, they would have incurred and additional $2.80 per square foot per year in rent.

Whether you’re negotiating a new lease or you are in the middle of your lease term, paying attention to operating expense language in the lease document and reviewing and reconciling operating expense statements with the provisions contained in the lease document every year can save you significant costs associated with your office space.

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