By Ed Muna
When tenants enter into a lease, in addition to the base rent, they typically are required to pay for their share of building operating expenses. This is true whether your lease is structured as “full service,” “modified gross,” or “triple net.” The intent is that these expense charges will increase at an inflationary rate over the lease period. Unfortunately, the truth in many buildings is that landlords do a poor job of controlling expenses, and tenants can be caught with surprising and very significant increases in their operating expense charges. Since these expense charges are not fixed like the base rent, variances can be painful, and negatively impact a business’ budget and bottom line.
Each year I see hundreds of operating expense statements, and more often than not expenses are increasing at a rate of 5% or greater. On occasion, I have even seen expenses increase more than 20% year over year.
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One of the biggest contributors to such an abnormality is the inclusion of a capital expenditure in the operating expenses. Capital can include everything from a lobby remodel, to the replacement of major equipment, to a new fitness center or roof. In one recent review of a client’s operating expenses from one very large and well-respected landlord, our team saw a 25% increase in overall expenses. Looking deeper, we discovered that a significant, six-figure inclusion of capital was responsible for the increase.
Steps Businesses Can Take to Reduce Exposure of Capital
By its very nature, a capital spend is a big number, but it is also one that typically is controllable and planned in advance by the landlord. As a tenant and business owner there are steps that can be taken to minimize the impact of capital expenses, and prevent excessive increases in your share of the operating expenses your landlord will ask you to pay.
- Going into the lease, your tenant representative should work to eliminate or reduce the capital expenses that the landlord may include under operating expenses. The argument is that if a major building system cannot survive your lease term, then the landlord should be willing to make the investment to justify the rent you are being asked to pay. Each landlord takes a different position when it comes to their willingness to give on this issue, but at a minimum most will agree to limit the capital expenses permitted to the amortized amount of those required by new laws after the lease commences, or improvements that will result in energy savings, which will “wash out” the inclusion of such amortized capital.
- If the landlord is unwilling to compromise on capital expenses, then you, as the tenant, need to evaluate your exposure before entering into the lease. One smart move is to ask to see the building’s five-year capital plan. Taking this step may help uncover a major upcoming investment (that you will be paying for) and help explain why the landlord took their position. At that point you can weigh the anticipated impact of an increase in expenses in your decision to enter into the lease.
- During the lease term, it is critical that you carefully review the annual operating expense budgets and reconciliations received each year. Because landlords have creative ways of hiding capital, it is always best to utilize a professional to evaluate these charges if your expenses are increasing by more than 3%.
While most building operating expenses are recurring and can be expected to increase with inflation, the introduction of an unanticipated charge for capital expenditures can seriously impact a tenant’s budget and bottom line. Commercial real estate leases are written to protect the landlord and give them as many liberties as possible. Unfortunately, this often results in landlords taking advantage of tenants by charging excessive expenses that offer little benefit to the tenant, but greatly enhance the landlord’s long-term investment.
To avoid these costly situations, it is important to have the right tenant representation from the beginning to ensure you are protected in your lease. Most of all, be sure to scrutinize the operating expense budgets and reconciliations you receive from your landlord each year, and ask a professional to review any suspicious charges.
Ed Muna is a senior vice president of Hughes Marino, an award-winning California commercial real estate company specializing in tenant representation and building purchases with offices in San Diego, Orange County, Los Angeles, San Francisco and Silicon Valley. 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.