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Operating Expense and Tax Escalation Issues
Is Your Money Flying Away?
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This is the time of year when property managers everywhere are busy preparing the common area maintenance (CAM) reconciliation’s for the properties they manage. After spending the past week calculating each tenant’s share of the increased expenses for three buildings that comprise a 400,000 square foot industrial warehouse complex, I felt that operating expenses would be an appropriate topic for this edition of the newsletter. If you are unfamiliar with any of the terms used below, you can click here to access the Glossary.
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Escalation Clauses - A Primer
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Although there are as many variations of escalation clauses as there are leases, all are intended to adjust rents by reference to external standards such as published indexes, negotiated wage levels, or expenses related to the ownership and operation of buildings. During the past thirty years, landlords have developed the custom of separating the base rent for the occupancy of the leased premises from escalation rent. This technique enables the landlord to better ensure that the “net” rent received under the lease will not be reduced by the normal costs of operating and maintaining the property. In addition, the landlord is able to quote a lower rent to attract tenants while protecting itself against inflation and fluctuation in operating expense and tax levels over the term of the lease.
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Essentially, operating expense and property tax escalation clauses require the tenant to pay increases in building expenses. Typically, this obligates the tenant to pay its share over a base amount, which can be the actual amount of operating expenses for an agreed upon “base year” or an agreed upon amount of expenses, often referred to as an “expense stop”. The use of a base year or expense stop is generally known as the “full service” method and is contrasted with the “net” lease approach, where all operating expenses are paid by the tenants and the base rent is correspondingly lowered.
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An Interesting History Lesson
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In the early 80’s it became common for office buildings to quote a “market rate” expense stop. In essence, all the landlords in the same geographical area with similar properties would incorporate the same expense stop into their quoted rental rate. The problem was that this “market rate” stop didn’t necessarily bear any relationship to the actual operating costs of a particular building. By this I mean that the "market rate" stop might have been $4.00 per square foot per year while a particular building's operating expenses during the preceding year were much higher, say $4.75 per square foot. If the tenant didn't know that this was the case and given that operating expenses rarely decrease, then an unpleasant surprise was in store because the tenant had unknowingly obligated themselves to pay this addition $0.75 per square foot.
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Most tenants, being generally unsophisticated at the time, didn’t often inquire about or compare one building’s operating costs with another. After realizing that they had obligated themselves to a higher cost of occupancy than anticipated, most tenants felt misled by their landlord’s failure to fully disclose anticipated costs. In the landlord’s defense, it probably wasn’t their responsibility to educate every prospective tenant looking at space in their building and in any case, an increase in the expense stop would have merely resulted in a corresponding increase in the quoted rental rate. In essence, a “pay me now or pay me later” type of scenario in which the tenant’s occupancy costs would have been the same, regardless. Unfortunately for landlords, the bad feelings that were generated resulted in a feeling of buyer beware and an entire industry began to develop around the concept of representing tenants in their negotiations with building owners.
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I Owe How Much!!!!
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Often, the invoice that a tenant receives for their pro-rata share of the building’s operating costs can come as quite a shock and have a severe, negative impact on their cash flow projections. Even after having properly negotiated the provisions of their lease, tenants often fail to fully grasp the effect that the escalation clause will have on their cash flow.
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Typically, people tend to think about the potential for increased operational costs in terms of inflation. If inflation is benign, as it is now, the feeling is that any increase in cost just can’t be that painful. The problem, of course, is that when their lease includes a provision for an expense stop, the landlord is presumably responsible for a significant portion of the operational expenses. In that the expense stop caps the landlord’s liability (see "An Illustration" below), the tenant bears the burden of inflationary pressures on the entire amount of the building’s operational cost.
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An Illustration
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In order to put this in the proper perspective, let’s consider the following scenario. (If you hate story problems, I really apologize but sometimes they just can’t be avoided.) Let’s assume that you are a tenant and the “base year” expense stop in your office building lease is set at $7.00 per square foot per year. Let’s further assume that, during the subsequent calendar year, the building’s expenses increase by only four percent over the prior year. This results in a $0.28 per square foot increase (i.e. 7.00 x 104% = 7.28), all of which you, the tenant, get to pay. If you occupied, say, 5,000 square feet, this would result in a $1,400 invoice from your landlord.
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Now, lets look at what happens in the following year. Again, the building only experiences a modest 4% increase in operating costs but now the base amount subject to inflationary pressures is $7.28 per square foot. This results in a $0.57 per square foot increase (i.e. 7.28 x 104% = 7.57), all of which you, again, get to pay. Still assuming that you occupied 5,000 square feet, your annual expenditure would now be $2,850 which means that your cost more than doubled in one year! If this thought frightens you, think about how an increased rate of inflation or an extraordinary increase in property taxes could compound this negative effect on your cash flow.
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If a tenant has not thought in these terms when projecting out their future exposure to costs, is it any wonder that they are too often shocked when the landlord's invoice arrives after year end?
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A Sample Invoice
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Since you might really hate story problems, perhaps showing you the actual calculation will help bring the concept into better focus. To that end, an actual tax and operating expense reconciliation appears below. Please note that a summary outline, by major account, of the expenses incurred during the year would also accompany the invoice.
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