By John Beck, Esq.
A few months ago, we shared a short list of topics for lease negotiators based upon the issues we see as auditors. With new year upon us, we think it’s a good time to share the rest of our tips.
Our belief is that tightening up your operating expense provisions from the outset of lease negotiations, beginning with your Request for Proposal (RFP), is the best method for controlling future occupancy costs.
Now, we give you Part 2 of the HOT TOPICS for operating expense negotiations:
1. The management fee should have a fixed cap, be consistent with the base year, and not at the “market” rate
One reason that tenants choose to enter leases is the predictability of expenses for budgeting purposes. Setting a cap for management fees lends itself to this purpose. We recommend language that's similar to: “landlord’s actual out-of-pocket cost of building management not to exceed __%”.
Negotiating a management fee rate that is consistent with the rate of the base year also makes sense, so that you don’t end up paying an escalation on a management fee that should be “baked” into your base rent.
Finally, we advise clients to avoid using market rate language. Sometimes the market rate is readily discoverable and agreed upon. Other times, as with market rates on base rent, the market rate issue can be contentious and may require dispute resolution procedures to bring all market information to light.
2. Eliminate “ownership” costs from the allowable operating expenses
Never, never, ever agree to pay for “ownership” costs as part of your operating expenses. Some landlords will attempt to insert this blanket category of costs in the basic definition of operating expenses. Ownership costs (i.e. leasing commissions, legal fees related to lease disputes, mortgage interest, and asset management fees) should not be the responsibility of the tenant. Tenant’s obligation to reimburse for operating expenses should be limited to “operating and managing” the property and should not include the costs of being a property owner.
3. Exclude corporate allocations of IT, Risk, HR, etc.
Corporate back-office allocations are becoming an increasingly popular type of expense to charge back to tenants. This is especially common among REITs and large institutional owners. They often argue that the allocation is a fractional cost of the actual function, and therefore is cheaper than a full-time, property-level employee performing the same function. However, the expenses often don’t fall into the “operating and managing” requirement of operating expenses. We also reject the argument that allocated back-office expenses are cheaper than providing full-time employees to perform the specific function, because on a property-level, these functions can often be performed by 3rd party vendors at competitive rates.
4. Allow for an increase to base year operating expenses when comparative year expenses add new services or costs
If you are negotiating a base year or expense stop in your lease, be sure to include language that will allow the base year or expense stop to be adjusted for new services or costs. The idea here is to stop the landlord from unilaterally adding services which did not exist in the base year to the building’s operating expense pool. If other tenants request new services, you should have some mechanism in your lease to shield you from the additional cost. As always, the landlord can reach out to tenants to negotiate new terms to the operating expenses if such new services are essential to building operations. In practice, the base year and comparative year expenses should be similar enough to make a line-by-line comparison on your annual statements.
5. Audit language: don’t agree to short audit windows or CPA requirements
Should be self-explanatory, right? Why are lease negotiators continually bowing to landlord wishes to restrict and reduce lease audit rights? We will explore your legal right to audit in another post.
If your state allows for a certain number of years to bring suit for a breach of contract, why would you limit your time to discover (i.e. uncover through an audit) such breach to less than the same number of years? The IRS advises business owners to keep records for 3 – 7 years depending on the document for federal income tax purposes. Don’t believe landlords when they say that keeping records is burdensome!
And we have nothing against CPAs. It’s just that landlords typically push for a “nationally-recognized” CPA requirement to force tenant into a potentially cost-prohibitive audit decision. Additionally, the CPAs that execute lease audits at “nationally recognized” CPA firms are typically not experienced commercial real estate professionals.
As always, contact us if you wish to learn more about any of these topics, or if you’re
interested in scheduling our training presentation for your transactions team.
Our success is based on knowledge of how each occupancy dollar is consumed, calculated, and billed. We offer real estate industry experience from an operations, accounting, and engineering viewpoint; proven experience not offered by any other firm in the industry.
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