How to negotiate a lease to avoid excessive operating costs Featured

9:01pm EDT September 30, 2011
How to negotiate a lease to avoid excessive operating costs

Office buildings cost a lot of money to operate and maintain. The operating and tax expenses (OPEX) for mid-rise to institutional-quality high-rise office buildings in Los Angeles range between $11 to $16 per square foot per annum, or $5.5 to $8 million for a 500,000-square-foot building. OPEX is comprised of management fees, administration and overhead, utilities, janitorial, mechanical system maintenance and fees, window washing, parking maintenance and fees and landscaping along with myriad other taxes, fees and miscellaneous expenses.

“The OPEX section in a lease is typically very long and almost impossible to get through in one read without falling asleep. It is the quintessential boring-but-important topic,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “A primary responsibility for landlord brokers and property managers is to make certain that all of these operating costs are passed on to the tenants that occupy their buildings.”

Smart Business learned more from Chavez about how tenants can keep operating expenses from getting out of control.

What should tenants look out for concerning their operating and tax expenses?

Landlords employ a very strategic methodology when processing their OPEX. Most commercial office landlords use what is known in the industry as a ‘full service gross’ lease. Gross leases incorporate the rent and operating expenses into one rental rate number. They are either quoted annually or monthly as follows: $36 per rentable square foot per full service gross per annum, or $3 per rentable square foot per full service gross per month, depending upon the marketplace.

The OPEX for the first year of a gross lease is referred to as the ‘Base Year.’ The Base Year becomes the cost basis for OPEX over the lease term. Any cost increases to OPEX over and above the Base Year are passed on to the tenant as a portion of their pro rata share. One would presume that any decreases in OPEX would automatically be deducted from any accrued escalations, but that is not always the case.

How can this type of lease hurt the tenant?

Initially, OPEX may seem like a minor issue because the first year expenses in a gross lease are zero — it’s the Base Year. The second year ‘pass-throughs’ may have some modest increases that show up as additional rent on the monthly rent invoice. They are typically so small that tenants do not pay much attention to them. It’s the same for the second or perhaps even the third year. In or about the fourth year, the magic of compounding begins to take effect and that line item often grows to an alarmingly large number. What started at zero, and then a few hundred dollars per month, often grows to thousands of dollars per month in additional rent.

For example, if a base year OPEX is $15 per square foot, and expenses increase at 3.5 percent per annum, the OPEX will grow to $18.40 by the seventh year of the lease term. That $3.40-per-square-foot increase equates to $1.7 million in additional OPEX costs for a 500,000-square-foot building. Accordingly, a 25,000-square-foot tenant would pay $85,000 in annual OPEX costs given their 5 percent pro rata share of the building. This scenario can be even worse if the building is reassessed due to a change in ownership and increased taxes are passed on to the tenant. These are costs that were not likely budgeted for by the tenant. The OPEX costs were creatively camouflaged years ago when the lease was executed.

Tenants must be mindful that these pass-through expenses will likely continue to grow for the duration of the lease term and there may be very little, if anything, a tenant can do about it after the lease is signed.

How can a tenant avoid excessive escalations?

There are measures tenants can take to mitigate the fiscal impact of OPEX escalations. Action must be taken as part of specific and detailed negotiations before a lease is executed.

The primary areas of focus are i) exclusions from OPEX, ii) expense caps, iii) category protection, iv) audit rights and v) properly quantifying the tenant’s pro rata share. Moreover, the tenant must remain diligent every year to make certain all of their hard-fought exclusions and protections are being followed by the landlord when the OPEX is restated each year. It is often the case that a general OPEX statement is presented to all tenants in a building, and it is up to the tenant to recognize that their exclusions may not have been properly accounted for. Issues like this seem to be more pervasive during recessionary periods when landlords are looking for creative ways to bolster revenue.

Can tenants handle these issues on their own?

Tenants can expect landlords to negotiate very aggressively against the tenant safeguards listed above. Common landlord responses are that it is an accounting nightmare for the landlord to track a different set of exclusions for each tenant, or that the tenant is too small to merit such protection. Some landlords will go so far as to say that they ‘just don’t do it that way.’

As is the case with any important negotiation, understanding concepts is only the beginning of the process. Taking this understanding to a successful conclusion takes time, experience and expertise. Landlords are experts at their craft and practice it every day. Tenants typically sign a lease once every five to 10 years, and even the most sophisticated executive can be outmatched by an expert landlord. There are at least 50-plus exclusions and related protections that commercial real estate experts negotiating on behalf of tenants demand. Truly understanding which are the most important for you, and where to spend your time and focus, is a real challenge for novices.

When it comes to commercial office operating and tax expenses, one bad real estate decision can haunt a company for many years to come. Tenants that do not use a tenant-oriented broker and real estate lawyer often regret it after the lease is signed and the OPEX escalations begin to grow.

Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardianusa.net or (310) 882-2060.