Operating Expenses - A Primer

Generally, January is the time of year when your landlord will present you with an invoice for expenses - in addition to your base rent. This assumes - of course - that you lease your business home. However, if you own your business home - take heed - as you may be able to take a few more dollars from your left pocket and move them into your right pocket - by asking your occupant to pay for some stuff. This column is designed as a primer for these expenses.

Let’s define a couple of key terms - shall we?

Operating Expenses. Typically defined as the costs of maintaining the commercial real estate in which you reside.

Lease form. Forms of leases vary as widely as days of the week but commonly are either net or gross. Meaning - your base rent is net of the operating expenses - or in the case of a gross lease - your base rent includes operating expenses.

Now let’s dive in!

What expenses are included as operating expenses. Biggest in this category are property taxes. Currently, property taxes are based upon roughly 1% of the building’s assessed value. I say roughly because certain cities may add fractions to this percentage. You can easily check on the amount through your county assessor’s website. Next, insurance on the property - which is different from the liability policy you carry for your business and contents.

Finally, common area maintenance which is a broad category of expenses which can encompass mowing the grass, trimming the trees, sweeping the parking lot, disposing of the trash, exterior lights, property management, changing the air conditioner filters, and reserves for capital expenditures such as roof replacement. Treatment of these CAMs - as they are called - varies widely among owners. Simply, some may not bill for these until due whereas others may budget for them monthly. Still others may not ask for any reimbursement.

What expenses are not included in operating expenses. A major system replacement - such as a new roof or air conditioner - or, changes made to the exterior of the building - like new pavement or parking lot lighting - falls into a class known as capital expenditures. As noted above - some landlords budget for these through reserves while others bill their tenants when the changes occur. Please check your lease. Treatment of these costs should be outlined. Commonly - language allows your owner to bill you for portion of these expenses spread over time - but not a lump sum. Expenses related to accounting, mortgage interest, entity fees, and business licenses should not appear on your invoice.

Gotchas. If an ownership change occurred recently - property taxes will increase based upon the sales price. As a tenant - you generally shoulder this bump. Watch out for generalized expenses. Most leases allow for you to reasonably audit any expenses you’re asked to reimburse. If you don’t understand a line item or if your owner simply sends you a flat amount to pay - ask for back-up. Check to see if your lessor can require you to paint the exterior. This clause killed a deal for me recently. 

Finally, anticipate these costs when you negotiate your next lease or renewal. Simple things like asking for operating expense increases to be limited or moving a base year forward can save you loads.

Allen C. Buchanan, SIOR, is a pricipal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.com.

Five "Gotcha" Issues that All Occupants Should Negotiate

I provide Location Advice to owners and occupants of industrial buildings in Southern California. Approximately 3/4 of my activity is in leasing and lease renegotiation...either on behalf of a landlord (owner) or tenant (occupant). In my experience there at least five "gotcha" issues that should be addressed in any lease agreement. In my layman's opinion, The AIR lease addresses these issues quite thoroughly...with a few tweaks. In the case of an owner generated lease, the issues vary in their treatment. The five issues are: Operating Expenses; Capital Expenditures; Subordination, Non-Disturbance, and Attornment (SNDA); Rent Increases, and Miscellaneous. I will define each issue, and suggest "asks" during the lease negotiation. This is a layman's review as a CRE practitioner and should not alleviate the need to have all legal documents reviewed by counsel. These issues are from a California perspective and may vary by state.

Operating Expenses (Industrial):

Operating expenses, also known as Op Exes are the expenses that an owner incurs in the operation of a property. These expenses include, but may not be limited to, property taxes; property insurance; maintenance of the foundation, roof, and walls; landscape maintenance; maintenance of the building's systems...plumbing, electrical, HVAC, etc.; utilities; occupants share of the amortized capital expenditures, etc. The costs are sometimes referred to as NNN expenses or "gross-ups". These expenses vary greatly based upon an owner's management preferences but are largely skewed by the amount of property taxes. If you negotiate a NNN lease, the costs are paid in addition to your rent...either as due or monthly. If the lease is an industrial gross lease, the base year op exes are included in the base rent. I suggest postponing the base year until the first full year after the commencement of the lease. If the lease commences in February, this is a tough ask. If the lease commences in October...not so much. I suggest asking for a cap on the increases in op exes over the base year.

Capital Expenditures:

Capital Expenditures are expenses that are largely non recurring such as roof replacement, parking lot replacement, drive and landscape modifications, etc. I suggest there be a mechanism in the lease to specify that any expense that exceeds 50% of the cost to replace a capital system (roof), be the responsibility of the owner and the cost be amortized over 12 years at an agreeable rate of interest.

Subordination, Non Disturbance, and Attornment:

This is defined as the financing holder's means of securing their interest and the outcome of any foreclosure. Also known as an SNDA, this clause causes the lease to be subordinate to existing and future financing that is placed on the property. As a tenant, a request that the lease be non-disturbed (terms not modified), should be sought in return that the tenant agrees to attorn (recognize) an owner that becomes the owner through the foreclosure of the underlying debt. Requiring ALL of these is important in my opinion...especially during economic times that could suggest a high likelihood of foreclosure. I suggest that the lease clearly provide for ALL of the components...S, ND, and A, and that where possible the lender be persuaded to sign an SNDA recognizing the lease.

Rent Increases:

These are defined as increases in the rental schedule during the term of the lease. Generally the increases are throughout the term of the lease and could vary based upon the change that occurs in the CPI or some other index. Caps and Floors are always suggested to hedge against a rampant inflationary increase.

Miscellaneous:

Former and existing cabling removal, ADA requirements (and who is responsible), city permitting, subleasing and assigning, rent abatement vs FREE rent, and options to extend and purchase should all be carefully vetted and when necessary, negotiated.