I can hear it already, “John, really? Couldn’t you have picked a really tantalizing subject, instead of Operating Expenses and Tax Pass throughs for your first blog?” I know, it seems mundane, but the fact is that reading this will SAVE you MONEY!
Multiple terms are negotiated in a lease that affect cost, but rent (comprised of both base rent and operating expenses) is the ongoing and ever increasing cost throughout a lease term. This blog will focus on the Base Year type of lease (as opposed to a NNN or Modified Gross lease). The operating expense component of a lease can be very costly if not negotiated properly.
I recently reviewed a new clients operating expenses from a long term lease and found that the base year expenses had not been grossed up properly, nor audited during any of the first several years of the lease term. By the midpoint of the term some expenses had already doubled and the pass throughs represented one third of the total rent. Because the tenant had not audited the base year we could only recover a portion of the overcharges from the recent years statement, and that “portion” amounted to over $60,000! The artificially low base year was locked in and every year the expenses compounded. By the end of the lease term the property management fees had more than doubled!
How did this happen and how could it have been prevented?
Base Year leases can be a good tool for tenants in comparison to NNN leases where the tenant is responsible for its pro rata share of all expenses. Ostensibly, the Base Year lease shifts the burden of the expenses occurring during the base year on the Landlord, with the tenant being responsible for only the increases in subsequent years.
So, for you, the tenant, what does this actually mean?
You sign a lease that commences in January of 2013 and the lease has a “Base Year” of 2013. This means that the first 12 months of the lease will not have operating expense or tax pass increases passed through to the the tenant, because the Landlord is responsible for “Base Year” expenses. In 2014, the landlord will start billing monthly for the anticipated increases in expenses over the 2013 base year. Several months after 2014 ends the landlord will finalize the expenses and issue a statement that will ultimately bind the tenant to those expenses.
Let’s say expenses and taxes for the building in 2013 are $11.00 per square foot. This is the Base Year cost.
Then, 2014 expenses and taxes come in at $12.05 per square foot. The tenant’s share would be $1.05 per square foot (the increase over the base year of $11.00 above). Sounds fair until you ask,
“What if the building was only 50% occupied in the base year and 75% occupied in 2014?”
Think of it this way, if a building is only 50% leased, every expense, other than fixed expenses like taxes, will be artificially low. Electricity, gas, water, janitorial, maintenance and the management fee (usually a percentage of rent) will need to be “grossed up” to reflect a fully occupied building offering full service to each tenant. Otherwise, when the operating expenses increase (as they typically do), not only will the tenant pay for the normal increase, but they will pay for the increase due to the increased occupancy (which will drive up expenses due to more electrical consumption/janitorial etc. from the new tenants).
It works to protect the landlord too. Let’s say the building is 95% leased in the base year and 50% in the subsequent year. The landlord will gross up each year to 95% so that the can recover the appropriate amount from each tenant.
Now consider that “occupancy” is just one factor in that equation.
Take into account things like free rent, management fees, incentives, TI’s and the like, and you may just find yourself paying for the cost of services you never benefited from, or at best, more than your fair share of the increase!
The moral of the story is that auditing, or at least thoroughly reviewing Base Year operating expense statements is a must. If an audit of the Base Year is missed, the problem can compound throughout the entire lease term, and could end up costing you and your business a lot of money.