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Carefully Constructed
Rent Escalation Clauses Help Avoid Landlord-Tenant
Disputes |
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.
BASE YEARS
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:
a. 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.
b. 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.
c. 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.
d. 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.
EXPENSE STOPS
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:
a. 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.
b. 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;
c. Expenses for the preparation of space or other
work which the landlord performs for any tenant or prospective tenant
of the Building;
d. Expenses for insurable casualties;
e. Expenses incurred in leasing or obtaining new
tenants or retaining existing tenants, such as, but not limited to,
leasing commissions, advertising or promotion;
f. 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;
g. Expenses incurred for any necessary replacement
that is under warranty;
h. Any cost associated with the business income of
the Building, including accounting and legal fees relating to
ownership, construction, leasing, sale or litigation;
i. The cost of correcting defects in the
construction of the Building or in the Building equipment;
j. Salaries for individuals beyond the level of
building manager, and Landlord's general overhead expenses not related
to the Building;
k. 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.
SUMMARY
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.
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