What Does Your Operating Expense Cap Language Really Mean?

By Janet Forrest, MBA

Senior Auditor, Account Manager

Adding language to a lease to place a cap on escalating operating expenses is relatively easy to draft, but the administration of these caps can be tricky. Operating expense caps can apply only to controllable expenses, or to all operating expenses; the capped rate can be simple or compounded annually, or they can be cumulative from the first year of the lease. The cap might be calculated from the building’s total operating expenses, or only from the final amount that the tenant pays. There are many variations in expense cap language and potential for errors by even the most conscientious landlords.

Controllable Expense Caps - This cap is used to protect the landlord from bearing the bulk of the cost increases over which he has relatively little or no influence. Typically, the uncontrollable costs will be defined in the lease language and may include real estate taxes, utilities and insurance charges. Expenses other than these that are categorized as uncontrollable should be carefully examined to determine if the landlord actually is able to influence the rates. For example, bids can be solicited for many building contracts and management fees can be negotiated with the owner, therefore, these would be controllable costs.

Simple Expense Caps - Simple expense caps look back only one year. The language often states that the current years operating expenses (or tenant’s share thereof) cannot exceed a specified percentage, say 4%, of the prior year’s operating expenses (or tenant’s share thereof). The application of this cap is relatively easy—multiply last year’s operating expenses (or tenant’s share thereof) by 104% to determine the current year maximum.

Cumulative Expense Caps - This cap percentage accumulates as the years pass. Using the above 4% per year cap example, capped expenses for the second lease year are 104% of the prior year’s expenses, capped expenses for the third lease year are 108% of the first year’s expenses, 112% in the fourth year and 116% of the initial year’s expenses in the fifth lease year.

Compounded Expense Caps - This cap tends to favor the landlord, as it allows greater annual expense increases than the cumulative cap. Again using the 4% per year example, capped expenses for the second lease year are 104% of the initial year. Expenses for the third lease year are calculated by multiplying the second year’s capped expenses by another 104%, resulting in an allowable increase of 108.16% over the first lease year. By the fifth lease year, the compounding effect increases the cap to 116.98% of the initial lease year expenses.

Caps and Base Years - Unless a base year is involved, it does not matter if the cap is applied to the total operating expenses or to the tenant’s pro-rata share of the operating expenses. Since base year operating expenses are reduced by a constant, unchanging stop or base year amount, the tenant’s pro-rata share of expenses may increase more dramatically than without the unchanging reduction. It is important to understand whether the operating expenses should be capped before subtraction of the base year or after the base year is subtracted and the tenant’s pro-rata share of operating expenses is calculated.

Operating expense caps become even more complicated when controllable, cumulative and compounded properties are combined to arrive at the final capped amount of operating expenses that the tenant should be charged. For a thorough analysis of your operating expense cap calculation, please contact Chelepis.

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