Real Estate Leases: Reviewing Annual Operating Expense Statements

By Stephen H. Berardi 

 

Each year, commercial tenants with pass-through costs included in their lease agreements receive the annual Operating Expense Reconciliation Statement from the property owners.  Typically prepared mid-year for the prior calendar year, the statement reflects the tenant's obligation to pay its share of increases in the total occupancy costs of the building, often one of the highest operating expenses after payroll and benefits.

Tenants often accept the idea that increasing costs constantly chip away at the property owner’s profit margin that was carefully calculated into the basic rent set when the lease was executed.  In order to preserve the profit margin, landlords expect the building tenants to absorb increased costs of operating the building due to higher property taxes, common area maintenance charges and a higher level of services.  Even though tenants are aware of the annual escalation clause in their leases, they are often taken by surprise when the statement shows expenses much higher than anticipated.  The question that often comes to mind is whether increases have been properly calculated, and whether some costs have been improperly included.  At the very minimum, the tenant should carefully review the provisions of the lease agreement and compare the cost items in the reconciliation statement with the language of the operating lease escalation clauses.

•  Salaries: The landlord may include salaries paid to all of its personnel, including cleaning and security staff, managing agent, executives, and other staff members.  The tenant, on the other hand, will not wish to pay the salaries of the landlord's staff (or the landlord's own salary), since these are not directly attributable to the tenant's occupancy of space. Usually, only the salaries of the managing agent and his/her subordinates are included in operating expenses; the salaries of many other employees are excluded.  In addition, when an outside management firm is used, its fees should approximate those paid by comparable buildings in the area. 
• Expenses for leasing space in the building: The landlord may seek to include expenses such as advertising and promotion incurred to obtain new tenants, as well as brokerage commissions and legal and administrative expenses relating to negotiating new leases or enforcing the terms of existing leases.  A tenant may possibly want to take the position that such expenses bear no relationship to the space the particular tenant leases in the building. 
• Overtime charges: Quite often, a tenant using its space outside of normal business hours must reimburse the landlord for the overtime costs of HVAC (heating, ventilation, and air conditioning) and sometimes for the costs of a security guard or freight elevator.  Such costs are often excluded from the escalation charges.   
• Capital expenditures: An operating expense clause in the lease agreement should be very specific in distinguishing repairs and maintenance from capital expenditures.  Operating expenses customarily include repairs to the common areas of the building, as well as to core building systems such as elevators, HVAC, lighting fixtures, wiring, security systems, and sprinkler systems.  On the other hand, the normal replacement of core systems, or costs incurred to correct structural, design or engineering defects, are often regarded as capital outlays that are the responsibility of the landlord.  When an expenditure is for the purpose of modernizing a building system that will reduce operating expenses in the future, the tenant's position should be that such costs may be treated as operating expenses only if the tenant will share in future savings resulting from the improvement.  One way to do this is to provide that the annual expense pass-through relating to the improvement will not exceed the amount of the annual cost savings to the tenant. 
• Outlays required by law: During the lease term, new laws or regulations may require unanticipated capital outlays.  For example, a new law may require the installation of equipment to improve air quality, or require the removal of asbestos or the purchase of new safety equipment.  The tenant may possibly want to take the position that such capital costs are one of the risks of property ownership and in addition, these costs increase the value of the building.  If the tenants are required to pay such costs, the allocation of the annual pass-through amount should be based on the estimated useful life of the new equipment. 
• Other charges: Other charges sometimes included in an operating expense reconciliation statement that may possibly be challenged by the tenant (unless clearly authorized by the terms of the lease) include: expenses for which the landlord has been or will be reimbursed by a third party; rent payments under a ground lease; the landlord's routine corporate and administrative overhead; debt service on a mortgage or any loan, fees or penalties; and any loss of value due to any form of depreciation.   

 

 

 

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