When considering a commercial office space lease, it’s important to carefully investigate any non-rental costs, what’s included in your rental agreement, and what you’re going to be responsible for on a monthly basis. While many commercial leases are likely to be triple net leases (in which the tenant is responsible for operating expenses on a pro rata basis in addition to the rental fee), these leases can be extremely varied and up to negotiation, leaving many tenants largely in the dark as to how much they can expect to spend each month.
In more popular and competitive markets, the operating costs can be as much as half of your base rental fee per square feet – and even higher in more concentrated downtown, financial, or business districts.
How Operating Expenses are Affected by Different Lease Types
Commercial real estate operating expenses include the costs for maintaining and operating a commercial property. These include rentals for office space, warehouse or industrial space, retail, and restaurant buildings. Depending on the lease agreement, you may pay a component of the gross rent, in addition to the base rent, or be included in the monthly rent entirely.
The different types of commercial real estate lease agreements vary greatly. They are:
Gross or Full Service Leases – Gross and full service leases include every operating cost in the monthly rent, including property taxes, utilities, and common area maintenance (CAM) costs.
Single Net Leases – Tenants pay a set cost for rent, property taxes, and utilities based on a portion of the space leased in the building. Landlords cover insurance fees and building expenses.
Double Net Leases – Similar to single net leases, those in a double net lease agreement pay a percentage of insurance fees and building operating expenses as well as all utilities. Landlords cover maintenance for common areas.
Triple Net Leases – Triple net leases involve part of the costs of property taxes, CAM costs, and property insurance expenses. These are the most common and popular net leases for industrial and retail properties because the expenses are based on a pro-rata share, or the amount of space a tenant takes up in their building.
Modified Gross or Modified Net Leases – A compromise between the needs of tenants and landlords, these lease types allow rent to be collected in a single payment and including all net expenses while utilities are covered entirely by the tenant.
Percentage Leases – Require tenants to pay a base rent as well as a monthly percentage based on sales. They are commonly used for retail spaces, shopping centers, and malls.
What Do Operating Expenses Include?
Depending on the nature of the commercial space and your market, the operating expenses tenants are responsible for may vary greatly and may include the following:
- Utilities such as gas/electric heating, water, and electricity.
- Maintenance costs to keep the building insured, functioning, and structurally sound.
- Professional building management fees.
- Property taxes (and any increases thereafter).
- Costs of supplies, landscaping, cleaning, and janitorial services.
- Insurance premiums and deductibles (including emergency coverages).
- Labor costs, legal fees, and accountant fees.
What Isn’t Included in Operating Expenses?
- Repair costs related to insured damage to the building.
- Any interest or principal on borrowed money or debt.
- Depreciation on the building.
- Any costs related to a breach of the tenant/landlord lease agreement.
- Costs or fees related to property sale or refinancing of the building.
- Penalties related to landlord’s failure to pay taxes, debt services, or assessments.
What’s Base Year and Pro Rata Share and How Do They Affect Your Monthly Operating Costs?
One of the biggest factors in determining operating expenses as a tenant is to research the stipulations of the lease agreement regarding the “base year.” In full service or modified gross leases, tenants pay base rent for the first year in the property without contributing to the building’s operating expenses.
However, following the first year of occupancy, tenants pay a pro rata share of the building’s operating expenses. This is usually determined by the percentage of the building’s space occupied by the tenant, so if you’re taking up 50% of the available space, you can expect to pay 50% of the building’s operational expenses.
Tenants should be aware that while the landlord is paying the operating expenses for the first year, whatever annual expenses they incur becomes the annual cap on the operating expenses for subsequent years of the lease. Should operating costs for the year reach $30,000, for example, and your organization takes up 50% of the building, your operational expenses for the second year of your lease agreement will be $15,000.
What to Look Out for When Negotiating Base Year and Pro Rata Operations Expenses
As with every lease agreement, you’ll want to consult with your real estate attorney and broker to ensure you’re informed of every potential pitfall.
1. Deferment of Upgrades and Major Repairs
One of the most common ways landlords leverage base year operating expenses in order to get more money from tenants later on in the lease agreement is by deferring maintenance of key systems or upgrades normally included in a CAM expense until after the first year of occupancy – or even longer. If your landlord stipulated that an annual rent increase is part of your lease terms, the longer these CAM expenses are delayed, the greater the increase you’ll see from your base year operating expenses. During the negotiation process, ask for the history of operational expenses for the previous few years so you can adequately prepare for a potential hike in operating expenses. Or, even better, negotiate a lease agreement that allows you to request an independent audit of the landlord’s expenses.
2. Variable Expenses and Unforeseen Increases
Another way landlords can squeeze more money out of their tenants is to charge increasing expenses based on usage – also known as “variable” expenses. For instance, if your operational expenses are pro rata and you’re only occupying part of an otherwise vacant facility, your costs will increase should a new tenant move in during your lease term.
Many tenants choose to protect themselves with a “gross-up” clause in their commercial real estate lease agreements. This protects tenants from escalating variable expenses and allows for base year expenses to more closely align with a fully occupied building later on in the terms of the lease.
Managing base year expenses and planning ahead for any potential increases can save you thousands – if not hundreds of thousands – over the life of your lease term. And more importantly, don’t let your landlord dictate the terms of your base year agreement without first consulting your broker and real estate attorney, making sure that your team is up to and aware of base year expenses, potential increase in operational expenses in following years, and how the landlord will handle those expenses. If you’re entering into lease negotiations and things seem to be moving against your favor, it’s probably in your best interest to start considering other commercial real estate space options.