Tenants often express shock, resentment and even embarrassment over the amount of rent and rent escalations that they are required to pay to their landlords. Conversely, when the landlord is confronted with the tenant’s concerns regarding these charges, its reaction is often one of puzzlement. From its perspective, the landlord has done nothing other than charge the tenant that which the lease calls for. Although there are many cases where these charges are erroneous, there are far more examples of where the tenant doesn’t understand the meaning of its lease.
The reason for this landlord-tenant tension is that many rent escalation clauses are not well drafted. We have found that what seems reasonable and clear at the time of oral negotiations is often not clearly expressed in the final document, making the lease unworkable in practical application. Consequently, these clauses invite conflicting future interpretations by landlords and tenants, many of whom were not party to the original transaction. The result? The parties often find themselves in a dispute that could have been avoided.
In order to avoid these disputes, it is well worth reviewing some of the salient points to be considered and clearly described when negotiating and drafting rent and rent escalation clauses.
Determining The Tenant’s Space
The first thing that the parties should do is know how much space is being rented, and make sure that the way the space is being “bought” is in the same manner as that in which the rent is expressed in the lease. A reference in a lease to “all of the space on the third floor” (which a tenant thinks is about 10,000 square feet in size) is not the same as “10,000 square feet on the third floor.” The former is a reference to space without particular regard to its actual size; the latter is. And if it turns out that the space is actually only 9,500 square feet in size, a tenant with the former language would be hard pressed to claim that it was being overcharged. Believe it or not, most leases today contain references to the space as “that space shown as the cross-hatched section of the floor plan on Exhibit A” and Exhibit A is only a quick, freehand marking of a floor plan without any references to dimensions, size or the like. Obviously, a tenant with language that makes detailed, specific reference to the space size has the best chance of reducing its rent should the size be less than expected.
In referencing space size, the lease must also clearly detail the specific standard upon which the space size is to be calculated. Should the space be measured to the inside or outside walls? Do common corridors count? Many landlords use the Building Owners and Managers Association (BOMA) measurement standard to determine the area of the demised premises and the building, but there are others. Whatever the standard, it should be understood by both sides.
Furthermore, once it is determined what standard of measurement is to be used, don’t forget to measure! The preferable time to do this is before the lease is signed, but if it is afterwards, then the tenant must make sure that the lease allows the rent to be adjusted to reflect the correct footage.
Services Included in Rent
Next, the lease must also be clear in defining the services the landlord is to provide at its sole expense as part of the base rent, which services the tenant is to provide and pay at its expense and which services are to be provided by the landlord but reimbursed to it via escalation or pass-through charges. There are several types of leases, each with different treatment of building operating costs:
Triple Net Leases–Leases in which the tenant controls the building services and pays the vendors directly. This is often the arrangement in industrial and retail leases. As these leases do not present the problems associated with the “pass-through” of expenses, they will not be discussed in this article.
Full Service Leases–Leases in buildings where the landlord operates the building and supplies building services (usually the case in office leases). These are usually of two types:
Net Leases–in which the costs of building operations are allocated and charged directly to the tenants proportionately.
Gross Leases–in which the landlord absorbs (and includes in the base rent) the cost of these services, with reimbursement by the tenants for increases in such costs that may occur in later years.
The most prevalent type used in office leases around the country today is the Full Service Gross Lease. It is here where one finds the now infamous Operating Expense Escalation Clause.
Operating Expense Escalation Clause
Many tenants and landlords are unaware that the purpose of these clauses is quite straightforward–it is to protect the landlord’s profit margin by allowing it to recover the “normal” inflationary-type cost increases in building services. Unfortunately, the clauses that are drafted to cover this goal are often not quite as straight forward, and often use complex formulas that convert the rent escalations into significant profit centers.
Base Operating Expense
In a full service gross lease, an operating expense escalation clause requires the tenant to pay the landlord for its share (based upon the percentage of the building it occupies) of the increases in such costs over a base amount (called the “operating expense base”). Base amounts can take two forms: a fixed dollar amount, called an “Expense Stop”, or the actual expenses incurred during a particular year, called a “Base Year.”
Although it may seem desirable to state the base as a fixed per square foot or aggregate dollar amount for the sake of simplicity, both parties must scrutinize this presentation in order to determine the basis upon which such amount was derived.
The reason is that, in most leases, the assumption made is that the tenant is getting all normal building services as part of the rent, and that the only purpose of the Escalation Clause is to protect the landlord’s profit on the lease from inflationary increases in the costs of such services. Thus, the premise for most leases is that the base amount should be the cost of operating the building at a normal level.
The lease with a Base Year seems to be the most accurate way to arrive at a true reflection of this intent. By saying in a lease that the tenant is required to pay for increases that occur in years after the year in which the lease commences, the tenant should not be at risk that the base amount is inadequate for the building.
There are, however, precautions that must be taken in drafting the lease to ensure that this goal is preserved. The lease should provide that the base year be subject to adjustments (“gross-ups”) in order to compensate for any atypical costs that do not appear in the base year. Some of these are as follows:
- Occupancy — Base year expenses should reflect the expenses that would have been incurred had the building been fully occupied at normal cost levels. Variable expenses which are generally subject to gross-up include utilities, cleaning and management fees.
- Warranties — In a newly constructed building, many of the building systems are under warranty. Consequently, the cost of maintaining such equipment during the warranty period is lower than during normal maintenance periods. Thus, the lease should provide that base year expenses should be adjusted to reflect normal maintenance costs in the absence of any warranties.
- New Services — In the event the landlord wishes to add a new service to the building, the cost of such service the first year it appears should be added to the Base so that the operating expense escalations do not include the entire cost of such service. This is especially true if the tenant thinks it is getting the new service as part of the rent. In the absence of adding such service to the Base, the cost should be excluded from the escalation unless the tenant consents to adding the service at its expense.
- Real Estate Taxes — The lease should provide that the base year for real estate taxes be the first year after the lease commencement in which the building has been assessed as fully completed and operational.
Note that providing for a gross-up of expenses where the building is not fully occupied or completed is not sufficient. Under this definition, the landlord might not be obligated (at least not pursuant to a literal reading of the lease) to adjust the base for free rent periods, where the space is occupied, but the rent stream is artificially deflated.
An Expense Stop is a way of short-circuiting the complexities of a Base Year lease. In a lease with an Expense Stop, both parties are agreeing to an amount for the base. Obviously, this amount can be either lower or higher than the actual amount it takes to run the building. If it is lower, then the tenant ends up paying additional rent for services it thought it was getting as part of its rent. If is higher, then the landlord doesn’t get full reimbursement for the increases in these costs. The danger in agreeing to any type of fixed amount is that each side is assuming the risk that the number is off the mark. And unfortunately for tenants, the landlord usually has much more information about building costs, and can take a more calculated risk than the tenant.
Operating Expense Inclusions and Exclusions
Inasmuch as the lease is requiring the tenant to pay a share of certain costs, there must be a definition of what those costs are. Leases will contain a description of the “pot” of expenses that are subject to escalation, which description will consist of a definition of inclusions in operating expenses and exclusions therefrom.
In defining inclusions, one must be careful to limit the costs to operating or maintenance costs and to not allow the inclusion of ownership costs. Ownership costs should be borne by the owners, and are not part of the costs to run the building. When it comes to exclusions, there are a large number of items that tenants should not be obligated to pay in their rent escalation commitment. Such costs should already be included by the landlord within the various components comprising the tenant’s base rent:
- Capital Expenditures, including any capital replacements, capital repairs or capital improvements made to the land, Building or Building systems. In addition, the lease should note that a group of smaller expenditures related to a capital project should be considered a single capital expenditure.
- The original cost, depreciation or amortization of the Building, its contents or components, or the initial development of the Real Property, including any ground rent;
- Expenses for the preparation of space or other work which the landlord performs for any tenant or prospective tenant of the Building;
- Expenses for insurable casualties;
- Expenses incurred in leasing or obtaining new tenants or retaining existing tenants, such as, but not limited to, leasing commissions, advertising or promotion;
- Interest, amortization or other costs associated with any mortgages, loans or any refinancing of the Building or land, bad debt loss, rent loss or reserves for either of them;
- Expenses incurred for any necessary replacement that is under warranty;
- Any cost associated with the business income of the Building, including accounting and legal fees relating to ownership, construction, leasing, sale or litigation;
- The cost of correcting defects in the construction of the Building or in the Building equipment;
- Salaries for individuals beyond the level of building manager, and Landlord’s general overhead expenses not related to the Building;
- Costs incurred in the removal or abatement of asbestos or other hazardous substances present in the building or on the real property.
Indexing of Rent
As an alternative to a complex operating expense clause, some landlords will protect their profit margins via an index, such as the CPI or Porters’ Wage. This may seem like a simple and fair way to provide for rent escalations, but both sides should be wary as there are a variety of indices with many subtle variations in common use, and their behavior can vary substantially. Both tenants and landlords should be sure to understand the implications of any index proposed as the basis for figuring escalations. A good idea is to include a sample calculation of the escalation in the lease, which illustrates the intent of the index formula being used. Be sure to show examples for at least two lease years.
Right to Audit Landlord Records
Of course, despite the inclusion of the most carefully drafted lease language regarding expense escalations, the parties are not entirely protected from disputes as to interpretation and application, nor the tenant from rent overcharges. Therefore, the lease should always allow the tenant or its representative to protest billings and to audit the landlord’s records. This right should not be limited because many tenants are not able to perform audits within a limited period of time as a result of corporate downsizing, and because problems often do not reveal themselves to tenants and landlords until after a number of years have passed.
To the landlords, if the tenant has engaged an experienced and reputable lease audit firm, the auditors should be asked to thoroughly explain their findings and take heed not to pursue dubious claims for overcharges. Of course, when the lease audit firm presents its findings to a landlord, then after should address legitimate audit findings and present its counter-arguments. Bad communication or failure to respond by either party can place unnecessary strain on the relationship.
Both parties should recognize that like any relationship, there will be disputes from time to time. While there may be those tenants and landlords who feel that an ambiguous lease can be an advantage, our experience has been that when disputes arise, those leases that are clearly written enable swift and amicable resolutions. Conversely, those leases that have been poorly constructed cause disputes that can escalate, costing thousands of dollars and broken relationships. This is why we recommend that each lease is constructed with the utmost care, and especially, that each side consider the true meaning of the printed words.