A major component (30% or more) of an office tenant’s rent bill is property taxes & operating expenses (“T&O”) which today is on the rise and where tenants have limited control under landlord-favorable leases. In Chicago, T&O is rising significantly and where most buildings quote rents on a “net” basis (which may be comparable), the amount of T&O can vary significantly among buildings. While tenants and their advisors will fight hard on the rent and other deal terms, if T&O is not properly vetted and negotiated, those deal terms will be far outweighed by surprisingly large T&O costs. In this post, I discuss the two common rent structures and offer strategies on limiting increases in T&O to provide tenants with cost certainty.
- Rent Structures: Net -vs- Gross. While there’s lack of consensus on the terminology (i.e, triple net, modified gross, etc..), office lease rent structures boil down to two structures, “Net” or “Gross”, both of which provide a basis where landlord and tenant allocate T&O through cost sharing. The landlord’s objective is to recoup T&O (along with any increases) to preserve its net operating income as well as its ROI. By contrast, tenants reasonably expect to pay for T&O (and increases) which are operational in nature.
- Net Rent – tenant pays its “net” rent plus its proportionate share (relative to neighboring tenants) of T&O. To illustrate, on an annual basis, where the net rent is $20/sf and T&O is $10/sf, then tenant’s total rent is $30/sf.
- Gross Rent – tenant pays its “Gross” rent and is responsible for increases in its proportionate share of T&O that exceed the Base Year or Stop amount. The Base Year is typically the first calendar year of the lease; however, a savvy tenant who wants its Base Year to be as high as possible may request that it be the following calendar year, which is particularly fair where the term starts in the 3rd or 4th For example, if the Base Year is 2017, a tenant wouldn’t face any T&O liability until 2018 assuming an increase in T&O from 2017. A “Stop” is somewhat of a misnomer for tenants, as one would naturally think that would be the limit of their T&O liability; however, as the lease is drafted to the landlord’s advantage, the Stop is the amount where the landlord’s T&O liability ends and the tenant’s liability begins. Unless the Stop will exceed the first calendar year, tenants should avoid the “Stop” structure As an aside, there are some leases (typically subleases) which are referred to as a “pure gross” lease where there is no T&O rent payment by tenants.
- Which rent structure is best for tenants? I’m asked this occasionally by clients, as tenants are looking to minimize their costs and have some reasonable predictability. While they should be cost equivalent to the tenant in a balanced market, if properly negotiated, the Gross rent is more tenant favorable as the landlord bears the risk on T&O for the initial year assuming a “Base Year”; however, in a weakening market where T&O are on the decline, the tenant may be better served with a net rent structure. Conversely, where T&O are on the rise, tenants may find a Gross rent structure more beneficial.
- When Gross Rent is Unfavorable. In some markets, a Gross rent structure may not be most favorable to the tenant where the landlord’s T&O are artificially reduced; a common example in Chicago (and other markets) is property tax reduction due to landmark or historical significance. These landlords quote Gross rents consistent with comparable buildings on a net basis, but they are effectively receiving a higher net rental rate given their reduced taxes. Savvy tenants with leverage should challenge these landlords and explore structuring their rent on a net basis.
- How to Limit T&O. Before discussing strategies to limit T&O, there are 3 principles to keep in mind: (i) expenses which are “capital” in nature and inure to ownership long-term should be borne by landlords; (ii) expenses which are “operational” in nature should be borne by tenants; and (iii) as office buildings change hands frequently, tenants should not assume that their future landlord will be benevolent in charging T&O. In fact, as buildings are trading for record prices based upon the assumption of rent growth, we’re seeing new landlords look to maximize revenue which can include aggressive treatment of T&O.
- Market Due Diligence. Limiting T&O begins well before negotiating a lease. It starts with in depth market research and building due diligence. As mentioned above, while in Chicago we see buildings with comparable asking “net” rents, the T&O will vary considerably. In evaluating office buildings, the tenant’s broker should examine historical T&O estimates for the current year and status of tax assessments.
- RFP – historical T&O. After touring buildings, the tenant’s broker should include in the RFP to the short-list candidates a request for an itemized list of key T&O line items for the past 3 years as well as the estimate for the current calendar year. This is a great tool to identify any “red flags” and dive deeper into why one building may have higher or lower T&O.
- Base Year. Where a Gross lease is most favorable and a Base Year is being proposed, the Base Year should be the first full calendar year. It also should be adjusted (“grossed-up”) to assume the building is fully occupied and taxes are fully assessed. “Grossing-up” is a somewhat perplexing concept which landlords request so that expenses are fairly allocated where the building is not fully occupied. The expenses to be adjusted should be those which vary based upon occupancy. To illustrate, if a 100K sf building is fully occupied and utility service is $1/sf, a tenant leasing 25K sf (leasing 25% of the building) should pay $25K (25% of $100K). If, however, the building is 50% occupied, the building’s utility costs are $50K. Should the 25K sf tenant pay 25% of $50K (or $15K)? If so, then the landlord is required to pay the additional $12,500 which the tenant has consumed. To avoid this inequity, landlords extrapolate these variable costs to assume the building is fully occupied. Leases commonly gross-up T&O for lease years, but they typically do not gross-up the Base Year. A grossed-up Base Year safeguards the tenant from having an artificially low Base Year due to low occupancy. Additionally, any renewal option should provide tenant with a new Base Year.
- Annual Cap. In the RFP, to maintain maximum leverage, request that tenant’s liability to T&O shall be limited to a fixed % increase., i.e., 3%. As there are certain items outside the landlord’s control, the fair compromise is to link the cap to “controllable expenses”. Of course, the landlord will offer an over inclusive definition of “controllable expenses”. Ideally, the tenant should agree that “controllable expenses” are “all expenses other than insurance, taxes and utilities (to the extent not caused by excessive use by owner or occupants).”
- Laundry List Exclusions. As leases are drafted by landlords to their advantage and to provide the landlord with flexibility to charge for certain unforeseen costs, they contain a very broad definition of what they can charge tenants as T&O. While they will commonly provide a short list of exclusions to what constitutes a T&O, the tenant’s broker should have a laundry list of exclusions to close any loopholes. This should be introduced no later than the Letter of Intent stage.
- Measurement. Be certain that the Premises is measured in accordance with the agreed-upon measurement standard. Likewise, to determine pro rata share (based upon a fraction where the numerator is the Premises’ rentable area and the denominator is the Building’s rentable area), be certain the building’s rentable area is measured in accordance with the agreed-upon measurement standard. For tips on office space measurement, see my post – “How Does Your Office Measure Up?”
- Audit Right. What good is this T&O language the tenant fought so hard for if they cannot investigate or contest any unusual T&O charges? To be introduced with the RFP should be the tenant’s right to audit T&O charges. In addition to inspecting landlord’s records at its office, practically speaking, it should also include the right to request electronic copies of all records to be sent to tenant and/or its auditor, as many T&O discrepancies can be resolved more cost effectively through a “desk audit”. Among the issues to consider in negotiating this audit right, is for the tenant to be reimbursed for its audit fees in addition to a prompt refund of any overcharges. Along these lines, the tenant should have the freedom to have its auditor compensated on a contingent fee basis. Landlords, to curb audit abuse, will commonly insist that the audit be conducted by a major accounting firm, CPA and/or not allow any form of contingent compensation. Tenant should also be sure they have adequate time to conduct their audit. While landlords will resist, tenants should push to examine prior years’ charges, as an error likely may have been occurring over the term of the lease.
Blackacre Advisors LLC
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).