When preparing budgets, it is imperative to realize that a tenant’s liability for its share of increased operating expenses can rise at a completely different (and much higher) rate than the building’s expenses. Although building operating costs may inch up by only 3-4% per year, your liability will usually more than double the first year and rise thereafter by around 50%, 33.3%, 25%, and so on.
How can this be? It’s simple math. In leases with base years and expense stops, the tenant is obligated to pay only for increases over the base costs. The increases change much more drastically than the expenses themselves.
Let’s see how this works:
Assume a tenant signs a new lease with a 2012 base year, and that the tenant is obligated to pay for 10% (its pro rata share) of increases over that amount. If the 2012 base year costs turn out to be $500,000, and are expected to rise in 2013 by 4%, they should reach $520,000 that year. In planning for 2013 costs, the tenant should budget for 10% of the $20,000 increase, or $2,000.
In 2014, the following year, if building costs are expected to rise by another 4%, they will rise by $20,800 to $540,800. The tenant, who is already paying $2,000, will now have to pay $4,080 instead. The change from $2,000 to $4,080 is 104%, a far cry from the 4% increase in the building’s expense levels.
Similarly, in 2015, if costs rise by another 4%, they will rise by $21,632, and the tenant will have to increase its $4,080 payment by another $2,163. This is a 53% increase over the prior year’s amount.
This concept applies to all escalations with base years or expenses stops. It is not in any way unfair; it is simply because the annual percentage change in a tenant’s escalation (a relatively small number) is much greater than the percentage change experienced by the building’s expenses as a whole (a much larger number).
When planning for the ongoing costs of a lease, remember to project out the anticipated cost increases based on these principles, and to explain that these are not unusual increases but are inherent in the lease structure.