Operating Expenses and Your Commercial Office Lease: What You Need to Know

by Mike Kushner, CCIM

Spring is the most common time of year for commercial real estate tenants to receive their operating expense reconciliations from their landlords or property managers as well as estimates for the current year. This can be an unexpected sum that is due, especially for small and medium-sized businesses who have budgeted for their commercial lease, but not the added expenses of reconciliations.

In the ideal world, the landlord has budgeted correctly, and no funds would be due for your past year of operations in the building. Unfortunately, this rarely occurs and tenants wind up receiving an invoice around April with their adjusted amount due from the previous year. The statement will likely have an estimate of cost over the base year amount which the tenant is required to pay monthly. But the surprises don’t stop there. As statements are issued, there are typically three months of estimates for the current year, known as “catch-up”, that also need to be paid upon presentation of the statement.

Office leases are generally structured as a full-service gross (FSG) lease, or a modified gross lease (MG). This allows landlords to “pass-through” the increase in costs of operating their building over the first year’s operating expenses, which is included in the rental rate for year one of your lease. Each year of the lease, the landlord will set forth a summary of costs for the past year and an estimate of costs for the current year, known as the reconciliation and estimate statement.

Upon receipt of the reconciliation and estimate statement, it is essential that tenants review and compare the cost against their previously received base year cost to ensure the billing is accurate. Keep in mind that leases typically provide a 30- to 60-day window to review pass-through costs that the landlord or property manager is asking you to pay.

Understanding the Operating Expenses

The term “operating expenses” is the general phrase used in commercial leases that includes all operating costs associated with repairing, maintaining, and operating a building. This includes common area maintenance (known as CAM), property taxes, insurance, utilities, management fees, and administrative fees. Sure, these costs go toward services that help your commercial space to function, provide comfort, and look nice. However, sometimes such costs can really add up and push you over the upper limit of your budget for your lease if you’re not aware of how they’re written into your lease.

What’s also important to understand is that CAM expenses are a subcategory of pass-through expenses. As your landlord or property manager makes repairs to the space, to areas that may or may not impact your daily use, you’re still paying into the expense that budgets for such repairs.

Negotiating CAM Costs

Because the cost to operate a commercial building generally varies from year to year, given changes in property tax rates, utility costs, and repair and maintenance costs, pass-through expenses need detailed attention when negotiating a lease. Tenants would be wise to take a closer look at the landlord’s expense provisions to prevent the burden of unexpected and rising costs.

Don’t just accept the terms of the lease. You should demand the landlord narrows their definition of operating expenses, as well as clear definitions of what constitutes a common area.

Landlords want to leave the scope of your share of operating costs as open-ended as possible, and often use terms that create loopholes for themselves that could leave you on the hook for an infinite number of unforeseeable costs. Whenever possible, insist that your landlord enumerate specific expenses, while minimizing or excluding catch-all phrases such as “all reasonable costs”.

Common areas are often another point of contention between tenants and landlords. It is reasonable to expect tenants to pay their fair share of the maintenance and repair costs in common areas – after all, the appearance and utility of the grounds and building are important for you to attract and accommodate customers. However, CAM expenses should exclude items such as the roof, exterior walls, and foundation of the building, as well as spaces that do not benefit all tenants.

How a Tenant Representative Can Help

A commercial real estate agent who is serving as your tenant representative can help guide you through the lease negotiation process, which includes determining pass-through and CAM costs. They are trained to identify where these costs are written in, and can help identify what is fair and what you might want to push back on. Compromises are made all the time in commercial real estate. With a trusted tenant representative on your side, you’ll have the knowledge and expertise to negotiate favorable terms that protect you from unnecessary costs.

Ensure that you have engaged a tenant representative to represent your interest in the process. This will not only serve you well as you search for and sign into commercial real estate, but they can serve as a trusted advisor when you encounter a challenge or an unexpected expense that could upset your business.

Are you ready to review your lease with a tenant representative? Contact our specialists today to get started.

This article was originally published on the Omni Realty Group website by Mike Kushner, CCIM. Omni was an exclusive buyer agent/tenant rep commercial real estate firm owned by Mr. Kushner prior to his joining the Capstone Commercial team. It has been adapted and reposted with permission. See the original article here.

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