How a simple error can result in significant overcharges
By Ed Muna
Often overlooked, the establishment of your Base Year is perhaps the most important operating expense statement you will receive from your landlord. Ironically, since you do not pay any excess operating expenses during this period, it is hard to make this review a priority. At Hughes Marino we encourage you to be proactive and review and understand your Base Year calculation. We have seen improper Base Year figures result in six figure errors to tenants over the life of a lease.
What is a “Base Year”?
In full service or modified gross leases, the landlord agrees to cover a tenant’s share of the annual operating expenses, but limits their annual exposure to an amount equal to the expenses incurred in the first year, or “Base Year.” The Base Year is therefore the actual (usually grossed up for full occupancy) operating expenses incurred by the building, usually in the first calendar year of a lease. Once established, this figure becomes the benchmark for future years to determine the tenant’s share of excess operating expenses, also referred to as “pass throughs” in many leases.
Example: During 2011 a building determines that operating expenses, grossed up for 95% or 100% occupancy based on the specifics of a lease, is $1,000,000. For a tenant establishing a Base Year in 2011, this $1 million figure becomes their “benchmark” for future years. If in year 2 expenses increase by 5% to $1,050,000, the tenant pays their prorate share of the $50,000 “excess operating expenses” (i.e. if the tenant occupies, 50% of the building, they owe 50% of this excess operating expenses in 2012, or $25,000).
Are you paying too much? Get peace of mind with a complimentary review of your commercial lease and operating expenses from the Hughes Marino Lease Audit team.
The Importance of an Accurate Base Year
Since the Base Year sets the benchmark for future excess operating expense charges, an inaccurate number can cost you for the life of your lease. The Hughes Marino Lease Audit Services division has seen errors in the Base Year which cost tenants significantly. In one case, Hughes Marino was able to correct an error for a client that will save them in excess of $200,000 over their lease term. The problem is, if not caught early, errors can be difficult to address in future years.
What to Look For?
When you receive your first annual reconciliation from your landlord, it will be very difficult to evaluate without some basis for comparison. You cannot get a better apples-to-apples comparison than from your own building. Ask the landlord for both a copy of the prior year (or two) operating expense statement and, if not already provided, the budget for the upcoming year. A thorough side-by-side evaluation of multiple years should make identifying discrepancies possible.
What Could Go Wrong?
The list of errors our lease audit division has identified is endless and growing with each audit. However, some common discrepancies include:
- Improper Gross-Up: If your building experienced a significant vacancy during your Base Year, make sure the landlord reasonably grossed up variable expenses to reflect a fully occupied building. For example, if the building was 50% occupied and the statements show $200,000 in electricity expenses, make sure that figure represents the landlord’s estimate of electricity costs at full occupancy. In a properly grossed-up expense, you would only expect to see normal 2-4% increases per year. However, if the expense was not properly grossed up, that figure could be significantly higher in the years ahead when occupancy increases and stabilizes.
- Deferral of Expenses: If you are a tenant that occupies a significant portion of the building, you need to watch out for a landlord that tightens the belt during the establishment of the Base Year knowing a delay in a significant expenditure will mean you pick up the lion’s share in the future. For example, if a property incurs a $50,000 expenditure and expenses it during your Base Year, your share will not only be zero, but your Base Year could have a cushion in the same amount for future years in which the expense does not occur. On the other extreme, some landlords might hold off on expenses that are not time sensitive until after the Base Year is established. Then, in year two when they loosen the purse strings, the excess spending becomes part of the amount they can pass through to you as excess expenses. The tell-tail sign of a landlord playing this game is significant increases in Repair and Maintenance expenses once the Base Year is established. Compare your Base Year to the following year’s budget to identify any red flags and ask for clarification if expenses increase unreasonably.
Example: Let’s assume your company occupies 50% of a building and you have a 2012 Base Year. The landlord plans to spend $1 million this year in OpEx. However, knowing that a significant Base Year is being established, an unscrupulous landlord could defer unnecessary expenses until 2013. Here’s what a deferral of $50,000 can cost you
- 2012 expenses and established Base Year amount: $950,000 ($1 million less $50k deferred)
- 2013 expenses and first year of pass through: $1,050,000 ($1 million budget plus $50k deferred from 2012)
The result is an excess $100,000 in OpEx over your Base Year, of which 50%, or $50,000 is your share. To make matters worse, that $50k the landlord deferred in 2012 will cost you annually for the balance of your term since all future pass through calls will utilize the intentionally lowered Base Year. Over the term of a lease, this error could easily cost a tenant in excess of $200,000!
The Bottom Line
When a Base Year is established, ask the landlord for a copy of the prior year expenses. Compare this to both the Base Year and the current year budget. Look for unusual fluctuations. Is the Base Year less than the prior year? Is the current year more than 3% of the Base Year? If so, ask questions and get answers.
At Hughes Marino, we established a lease audit division to ensure that landlords are billing operating expenses in compliance with the established lease and within industry standards and expectations. Contact us for more information.
Ed Muna is a senior vice president of Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices in San Diego, Orange County, Los Angeles, San Francisco, Silicon Valley and Seattle. Ed heads Hughes Marino’s Lease Administration and Audit Service divisions and helps tenants address issues that arise during their occupancy. Contact Ed at 1-844-NO-CONFLICT or firstname.lastname@example.org to learn more.