Tenants are often attracted to buildings because the buildings are undergoing renovations or other improvements to systems, appearance or operations. For example, a quick perusal of the commercial real estate section of a local newspaper will often reveal ads claiming “New Lobby” or “New 24/7 Security Desk” or “New Improved Elevators.”
In most cases, the rental rates offered for these spaces anticipate the improved conditions (the rents reflect the new Class A building rather than the old Class B building, for example). However, in base year leases, tenants can find themselves paying twice for maintaining these new improvements—once in their rental rate and again in the operating expenses—and must protect themselves in their lease language from such an occurrence.
Let’s explore how this can happen. In a modified gross lease with a base year (the typical structure for office leases), the rent includes the cost of what it takes to operate the building in an agreed year (the “base year”). The base year is typically the first year of the lease. Once the base year is established, the tenant is obligated to pay for increases in such costs over time, as measured by the increases in building operating expenses over the base year amount.*
If the base year is established when the improvements are still being placed into service, or warranties covering the new improvements are still in effect, the base year will not include the costs of maintaining the improvements at full levels. This could easily happen if the elevator modernization were still ongoing, or the security desk were not yet built or fully staffed. Once the elevators are in place, the service contract may be at a much higher level than the old contract. Similarly, once the security desk is finished, the staffing levels may be much greater than before. Although most leases exclude the costs of the actual improvements from operating expenses, they include the increased maintenance costs that results from such improvements. Because the base year didn’t have these increased levels, when the improvements become fully operational, the higher service levels show up as increases in the operating costs and the tenant has to pay for them. Given that the rent already reflects the improved building, this increase becomes a double-charge to the tenant.
Many leases contain “gross-up” clauses that require the landlord to adjust expenses to levels reflective of a fully occupied building.** However, the problem outlined above is not necessarily related to occupancy. The building can be fully occupied without the new maintenance costs being at full, normal levels. Gross-up clauses, in order to protect against these issues, must neutralize all atypical costs; i.e., the base year must be reflective of all of the normal costs of operating the building at normal levels. Where new improvements are being put in place, these normal levels must be defined as what would be present after the improvements are completed.
The same problem manifests itself with respect to real estate taxes. Real estate taxes are based on the assessed value of the building. When building improvements are added, the assessment generally rises. If the tenant’s rental rate is based on the assumption that the building will have been improved when it moves in, the tenant can find itself paying for the increased taxes twice—once in the rent and again in the tax increases caused by the addition of the improvements to the assessment.
To protect against these problems, whenever a tenant is moving into a building that has been or will be significantly renovated or upgraded, special attention should be given to the operating expense and real estate tax escalation provisions in order to ensure that the tenant does not pay any cost increases associated with bringing the building up to the higher level. Specifically, the base year operating expenses and taxes must be adjusted and/or grossed up to include all of the normal cost levels that would be present after the improvements are in place.
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