Understand How Operating Expense Costs Affect You

Understand How Operating Expense Costs Affect You

While there are many issues to be concerned with when signing a lease for commercial space, tenants often focus on what’s typically the most hotly contested provisions—exclusive use and cotenancy. The right to be the only tenant to sell a product in a center, or get the benefit of other stores that create helpful synergy, can boost that tenant’s bottom line. But profits can be undercut when a tenant doesn’t give equal consideration to another issue, one that can have dire financial consequences: operating expenses.

So it’s crucial for tenants to understand the concept of both operating expense costs and exclusions because they can cost tenants money if they’re not drafted properly. It’s important for new and experienced tenants to understand exactly what these are. Operating expenses are expenses incurred by the landlord in operating and maintaining the building. Tenants pay these operating expenses in addition to a fixed monthly rent because by occupying the building, they use and benefit from the services, equipment, and maintenance of the building. Essentially, operating expenses cover the landlord’s expenses of providing the building’s operation, which includes items like elevators and heating, ventilating, and air conditioning (HVAC), that are subject to wear and tear or breakdowns that require upgrades and maintenance. It’s completely reasonable for tenants to pay a proportionate share of these for the building.

The type of lease—“net” or “gross”—the tenant has will make a difference in the way that operating expenses affect its finances. So tenants should understand how these lease distinctions work.

Net leases. In net leases, the rent is net of operating expenses to the landlord and tenants pay their proportionate share of all the operating expenses and insurance and taxes of the building. Tenants pay the expenses without a base year.

Gross leases. In gross leases, the operating expenses for the first year of the lease are included in rent. That’s called a base year, and the tenant only pays the increase from the base year in the building’s operating expenses. In proportion, the tenant pays its increase; this is not intended to be a profit center for the landlord. It’s simply the reimbursement of actual expenses the landlord incurs in operating the building.

A tenant that wants its lease to provide that operating expenses are intended to reimburse the landlord only for its actual expenses needs to carefully draft this portion of the lease. The language should make sure that the operating expenses charged to the tenant don’t exceed the actual costs of operating the building; if you don’t have that language, landlords have ways of adding in costs that a tenant wouldn’t otherwise be obligated to pay.

For a drafting strategy that can help you avoid operating expense issues that can affect your bottom line, see “Avoid Common Pitfalls When Drafting Operating Expense Clause,” available to subscribers here