With the current hybrid working model’s impact on office building operating expenses and the fall in office building valuations, we have updated this post. (Originally posted 1/2016, updated 1/2022, 3/2024 and 3/2025)
As we near the end of 1Q 2025, ‘tis the season for Operating Expenses and Tax reconciliation for office tenants. As most office leases allow the landlord to recapture increases in Operating Expenses and Taxes (which tenants commonly pay on an estimated basis over a calendar year), landlords are required to reconcile the year’s actual expenses and taxes to the tenant’s estimated payments. That reconciliation statement is typically issued in first quarter. If not carefully reviewed by a tenant, in all likelihood, money is being left on the table as 90% of these statements have some errors.
With many office landlords struggling to stay afloat with rising costs, we are seeing some landlords take a more aggressive approach by passing-through to tenants expenses which have not been passed through in the past. Outlined below are strategies tenants should employ in reviewing these statements as well as some ideas on how to craft these provisions in future leases. I am joined on this post with Mirela Gabrovska and Elizabeth Faust of MBG Consulting, national experts in lease administration and auditing.
Key Market Changes Impacting Tax & Operating Expense Reconciliations
- Many companies are reducing their real estate footprint, retaining only core assets. The result is a smaller percentage share of expenses, which can significantly impact OPEX calculations and increase per-square-foot costs.
- With more properties changing hands, property management and accounting practices often shift. Tenants should be vigilant to identify changes in OPEX methodology and interpretation that could lead to overcharges.
- As ownership changes, annual insurance premiums must be prorated based on the number of months each owner has held the asset. Tenants should ensure they are not billed for overlapping coverage periods during these transitions.
- As many buildings are selling at large discounts, taxes should be reduced, while every owner has an incentive to minimize its tax bill.
- Commercial property insurance rates continue to rise due to effects of climate change and inflation.
Tenant Strategies:
- Watch the Clock. Check your lease to see how much time you have to review the reconciliation statement (audit window). Typically, office leases allow the tenant 30 days to review and object to the reconciliation statement. Absence of tenant’s timely objection is typically deemed to be binding acceptance of the statement. Note, in future leases, you should strive to obtain ample opportunity to review the statement before you waive your rights; best practice is 180 days. Landlords will push back arguing that they need to have closure on these statements, but tenants should not lose out on the protections they worked hard to negotiate into their lease.
- Landlord Delays. Labor shortages are also impacting some landlords’ ability to timely present the annual reconciliations to tenants. You need to consider any lease language that allows you to demand receipt of a reconciliation by a specific time, or, most favorably, excuse any liability for any deficit due under the reconciliation statement.
- Review Lease Definitions – Operating Expenses and Taxes. Your lease controls what the landlord can charge you for operating expenses and taxes. It is the final authority. Most leases contain an overly inclusive definition of Operating Expenses and Taxes to give the landlord latitude to preserve its cash flow in the face of rising Operating Expenses and Taxes. Savvy tenants and their advisors will negotiate into the lease an extensive list of exclusions to Operating Expenses and Taxes. Additionally, experienced tenants will (a) obtain an annual cap on increases in operating expenses which are in the “control” of the landlord, (b) negotiate special treatment for capital expenses, and (c) outline the expenditures which are solely landlord’s responsibility. Tenants should pay special attention when negotiating Base Years and outline the conditions of future year comparisons so that the increases over the Base Year are always equitable. Preserve the right to audit your Base Year too! A lot of negotiating capital may have gone into this provision and with significant additional rent costs at stake, you should not ignore it during the course of your lease.
- Billing errors on the rise. Recognizing the monumental task that landlords face in charging tenants operating expenses and taxes with differing lease provisions (varying based upon the sophistication of tenants), and despite their best intentions, landlords invariably make billing errors. 90% of the reconciliation statements have some errors. These errors are most prevalent following a building sale where landlords are inheriting leases they did not negotiate and lack familiarity as to the details. While building sale activity has been slow given high interest and vacancy rates, we are seeing a significant increase in financially strapped landlords surrendering their building to their lender who then inherits the lease. Further, many landlords hire outside accounting firms to conduct the reconciliation and such firms do not always review the operating expenses’ provisions for each individual tenant’s lease.
- Estoppel Certificates. When a property is sold or transferred, most leases require the tenant to sign a document called an Estoppel Certificate confirming facts about the lease. These documents must be carefully reviewed as I mention in my blog post What Tenants Need to Know About Estoppel Certificates – Blackacre Advisors LLC The Estoppel Certificate is a great vehicle to address errors or disputes in computing operating expense and tax liability.
- Benchmarking. Tenants should ask their broker to provide benchmark data of operating expenses and tax amounts at comparable buildings. This is a simple gut check exercise to see if the reconciliation statement is in line with the market. If the benchmark reveals any anomalies with the reconciliation statement, then the tenant knows where to focus its efforts on review.
- Common Errors. Some common errors and items to consider are:
- Grossing-up of variable with occupancy expenses, see my blog: Is it Fair That My Landlord can Artificially Inflate Operating Expenses? – Blackacre Advisors LLC
- Pro rata share calculation
- Misapplying the Base Year
- Grossing-up expenses of current years when the Base Year expenses are not grossed-up
- Capital expenditure treatment
- Management fees
- Expenditures due to change in law
- Not applying the annual negotiated cap on increases in expenses
- Charges attributable to a neighboring tenant
- Charges for services not available to all tenants
- Overhead fees
- Utility charges, surcharges, and usage allocation
- Hybrid Work’s impact and considerations.
- With many buildings experiencing high vacancy, how are “variable expenses” being grossed-up? Review the lease to see if the gross-up is based upon “occupancy” or “leased” or a combination thereof. Most leases gross-up the variable expenses based upon occupancy but don’t offer a definition of “occupancy” and with many tenants having staff work remotely on a hybrid basis, the term occupancy is a bit nebulous. Also carefully review your lease and determine what are considered “variable expenses”. It is important to request from the landlord its gross-up calculation and occupancy report.
- Where tenants have a cap on increases in “controllable expenses”, carefully examine your lease to determine what expenses are subject to this cap. If the lease gives the landlord latitude, they may dilute the cap with expenses that they can control.
- In negotiating any new lease in which there is a Base Year for tax and operating expense, be sure that Base Year amount is not artificially low due to low occupancy. It should be grossed-up to assume full occupancy and full tax assessment. Otherwise, the tenant will be paying unexpectedly higher expenses and taxes over the life of its lease.
- Utilities should be lower due to lower occupancy, however, that could be off-set where buildings are running HVAC systems longer to increase fresh air intake.
- Taxes may be lower if the tax assessor uses the income valuation method; high vacancy results in lower income. Taxes may also be lower if the tax assessor is using the Direct Comparison valuation method, given some recent building sales at significant discounts.
- Insurance costs have surged just as we see it on a personal basis. That is due to inflation, natural disasters, and changes in the reinsurance market. Tenants should ask the landlord for: (i) the insurance bills; (ii) the distribution list for blanket insurance over multiple properties; (iii) insurance declaration page which itemizes the types of insurance covered by the policy and the cost of each type.
- Higher labor and management fees due to labor shortages and inflation.
- Tenant’s Recourse – Audit Rights. Sophisticated tenants will negotiate into their lease the right to audit the landlord’s records following receipt of a reconciliation statement. This right will specify a timeframe for review of the landlord’s records. If there is an overcharge, tenants should also have the right to seek reimbursement from the landlord for their audit fees and receive interest on all overcharged amounts. To counter tenants that may employ contingent fee auditors and the related time of complying with numerous audits, landlords will usually insist that the auditor be a CPA (possibly a major firm) and specify no contingent based compensation. Tenants should avoid these restrictions as to who it employs as auditor and how they are compensated. Tenants should negotiate that documents will be made available to tenant electronically and with no restriction to conduct reviews at landlord’s offices only. To preclude a landlord from revisiting its prior reconciliation statements, well advised tenants will also negotiate a “sunset” provision.
We welcome your questions and an opportunity to help you navigate this process. Feel free to contact us.
Don Wenig – (312) 345-4778 – dwenig@blackacreadvisors.com
Mirela Gabrovska – (312) 216-2525 – M.Gabrovska@MBGConsulting.com
Don Wenig
Blackacre Advisors LLC
info@blackacreadvisors.com
312-345-4778
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).