Importance and Purpose of Operating Expenses
Landlords impose Opex charges against tenants for costs incurred in the operation of their premises by either (1) allocating such costs on a proportional basis, calculated according to each premises’ pro-rata share of an aggregate expenditure attributable to a larger building, campus, or center (a site) of which the tenants’ premises form a part, or (2) directly charging tenants for costs and services that are not already accounted for in the fixed rent rate, to the extent they are attributable to their respective premises, exclusively.
Examples of Opex charges that typically are calculated on a proportional basis include landlords’ costs in providing utilities to a larger multitenant site in which individual premises are not separately or sub-metered, as well as the expenses landlords incur in maintaining common areas of the same. Under these circumstances, it is inefficient, difficult, or even impossible to determine the exact amount of Opex charge for which each tenant should be responsible. So, landlords typically apportion the costs to tenants based on the proportion that the square footage or floor area of their respective premises X bears to the total square footage of the larger site Y; such proportion X/Y is then assigned to each tenant as its respective pro-rata share. This method of charging utilities based on pro-rata share of the occupied square footage is necessary because installing separate or sub-meters to identify the exact utility usage in each premise may be cumbersome.
Similarly, Opex charges associated with landlords’ maintenance of any common areas in multitenant sites are also usually calculated on a pro-rata basis based on square footage occupied. Because all tenants and their customers, guests, contractors, etc. enjoy joint use of such sites’ common hallways, walkways, or accessways; elevator bays and escalator banks; lobbies or food courts; as well as parking garages or lots, a precise allocation of costs for use of the same is not possible. The same is true for the other two primary Opex categories, landlords’ costs incurred in insuring a larger site and paying real estate taxes on the same.
Opex charges that are definitively attributable to only the premises, and no other premises or common areas—are the truest form of pass-through expenses, and are perhaps more typical of office leases (where premises are more often separately metered, especially if they encompass entire floors); leases of free-standing buildings constructed and owned by the tenant (such buildings may be directly insured by the tenant-owner); or leases covering the entirety of a separately assessed tax parcel (as a separate assessment allows the tenant to pay real estate taxes directly to the local taxing authority). In these scenarios, the Opex charges are easily ascertained because no other premises or tenants are benefitting from the services for which the tenant is being charged. Sometimes, tenants may be able to procure and pay for these primary Opex categories directly without their landlords’ involvement by paying utility providers, insurers, or taxing authorities directly. Other times, however, it may be more efficient for landlords to procure such services and pay such costs up-front, and instead require reimbursement from tenants for the same, as a form of additional rent.
Thus, Opex charges can constitute additional rent under a lease in a variety of ways: Some tenants may have all services and primary Opex categories procured by landlords, for which they reimburse their applicable Opex charges on a square-footage-based, pro-rata basis; other tenants may procure such services themselves and pay the associated Opex charges directly to the applicable provider or entity. Still other tenants may rely on landlords to secure or obtain services, but will instead reimburse landlords for the associated Opex charges on a direct basis, to the extent such calculation is feasible. The majority of tenants, however, rely on a combination of the above methods and scenarios.
Operating Expense Structures—Types of Leases
Commercial leases are classified routinely as (i) gross leases, (ii) net leases, or (iii) modified gross leases. Most in the real estate industry view these classifications as distinguishing which party is responsible for performing the obligations that result in the applicable Opex charges. Normally, (i) under true gross leases, landlords are 100 percent responsible; (ii) under true net leases, tenants are 100 percent responsible; while (iii) modified leases occupy a middle ground in the spectrum, under which such responsibility is split between the parties. In practice, regardless of their names, most lease agreements fall into this third modified lease category, as true or absolute gross or net leases are somewhat uncommon. Because practitioners vary in the use of these titles in their lease documents, it is important to avoid placing undue emphasis on a lease’s name, as that name may not accurately represent the agreement’s structure in the context of Opex charges (or otherwise).
A landlord under a true gross lease (sometimes called a full-service lease), for example, is responsible,theoretically, for the performance of all operational obligations related to the premises, and the tenant’s only contribution to the Opex charges arising out of the same must be incorporated into the fixed rent rate. Landlords under such full-service leases risk financial losses if their tenants consume more utilities or require more maintenance or service than was initially anticipated and factored into the fixed rent. Therefore, these types of leases have become less common in recent years. Still, there are certain types of office leases as well as single-purpose leases—such as those for billboards, other signage, or cell towers (or a residential lease)—that may be written as a full-service lease.
On the other end of the spectrum, a tenant under a true or absolute net lease (sometimes called a bondable or bankable lease) is responsible for the performance of all operational services and payment of all associated Opex charges. These payments and charges may include those connected with the exterior and roof of the premises, as well as costs associated with repairing or replacing damaged or destroyed premises, all of which are assumed to be the landlord’s responsibility. Such absolute net or bondable leases therefore are likely attractive only to tenants with significant and flexible cash flows who are sufficiently solvent to risk such financial liabilities. This may be attractive in exchange for an extremely long-term lease of premises over which the tenant has considerable control, or that they can pledge as collateral for a loan. Complicating matters further, many use the term “net” to describe any leasing arrangement in which Opex charges— those associated with the primary Opex categories—are passed through to the tenant via direct payment, reimbursement, or otherwise.
Accordingly, because each absolute end of the leasing spectrum suits only those landlords and tenants who meet rather limited and specific criteria, most leases fall somewhere in the middle of this range. These mid-range leases are best described as modified net or gross leases—again, the title of the lease is not a determinative or accurate description—that share both net and gross lease characteristics. In practice, most commercial leases bifurcate the responsibility for the (i) provision of the services related to the primary Opex categories and (ii) costs for such services via Opex charges. These bifurcated leases are one of the clearest examples of a hybrid arrangement. Theoretically, such leases are both (a) gross, meaning landlords are obligated to provide all operational services, and (b) net, meaning tenants are responsible for the payment of the Opex charges associated with those services. This basic structure (in which landlords procure or obtain the primary Opex categories, and the costs are passed through to the tenant via Opex charges) is perhaps most universal, as it is typically impractical (or sometimes even impossible) for either single party to both provide and pay for every single type and aspect of operational service. Thus, the vast majority of leases are of a modified structure, generally obligating landlords to provide all or some of the primary Opex categories and other services, while requiring tenants to contribute or reimburse landlords for such provision via their payment of Opex charges. The base-year lease discussed below is an example of a modified gross lease.
Tenant’s Pro-Rata Share
As noted above, many leases require tenants to contribute (almost always via reimbursement) to landlords’ Opex charges incurred in the operation of the premises and the larger site within which it is situated. Other than direct charges that can be verifiably associated with the premises exclusively (e.g., separately metered utilities or real estate taxes imposed against a separately assessed tax parcel), most such Opex charges are calculated according to the square-footage-based, pro-rata basis introduced above. The determination of the tenant’s pro-rata share is not always straightforward.
Standards for measurement of leased premises, generally fall into three categories: (1) aggregate or gross square footage (GSF), (2) usable square footage (USF), and (3) rentable square footage (RSF) (again, keep in mind that these are not standard terms that all leases or practitioners rely upon). GSF is the most basic measurement of any premises or larger site and typically includes everything from the exterior walls inward. USF, by contrast, includes only those portions of a given premises that the tenant can physically use per the terms of its lease.
The majority of commercial leases (except those negotiated by tenants with extreme leverage) will identify the size of a premises as equal to its GSF rather than its USF. Tenants should be aware that if they are paying fixed rent on a per-square-foot (psf) basis for their premises, then even the square footage (sf) they cannot use will be included in their fixed rent rate. Unusable areas might include elements like elevator shafts, emergency stairwells, mechanical and electrical closets, or janitorial corridors that are situated within the walls of a tenant’s premises. These may be included in its sf calculation for purposes of both fixed rent and Opex charges (to the extent the latter is payable on a pro-rata basis), even though they are not usable space. Some tenants may succeed in requiring the landlord to use their USF rather than GSF for these calculations, but likely only where the unusable space comprises a large portion of the premises or detracts in a material way from tenant’s use. Relied upon mainly in multitenant office building sites, RSF generally includes USF plus all areas that may be usable by a given tenant not exclusively, but rather jointly with (some or all) other tenants. In such office space sites, premises are often configured differently, with some tenants leasing entire (or multiple) floors and others sharing floors with one or more additional tenants. These differing configurations render unworkable the more straightforward pro-rata share calculation used in retail leases, as it is less discernible which common areas or other unusable spaces benefit which tenants. Instead of attempting painstakingly to examine and measure each common area and unusable space, office landlords instead (i) calculate the aggregate sf of unusable or common areas of the site and then (ii) impose Opex charges on their tenants by using each tenant’s USF to determine their pro-rata share (in terms of sf) of the aggregate common areas, which is then added to each tenants’ USF—the resulting sf being the RSF.
Allocating Responsibility for Operating Expenses
As with the other issues described in this article, landlords and tenants rarely agree on the extent to which each of the primary Opex categories are included as additional rent. This section will discuss some of the issues with respect to the primary Opex categories.
Taxes. At the least contentious end of the spectrum, taxes and insurance are two of the primary Opex categories on which landlords and tenants can reach relatively quick agreement. The responsibility for the payment of real estate taxes, for example, tends to be straightforward—for the most part, landlords will be responsible and then pass through to tenants a pro rata share of the real estate taxes. But in the case of some specific types of leases discussed above, tenants may pay taxes directly if they are leasing a separately assessed tax parcel. Disputed aspects of tax obligations arise with landlords’ attempts to require their tenants to pay portions of taxes other than typical real estate or ad valorem taxes. Some disputes involve penalty-like assessments that authorities may impose upon a tenant, landlord, premises, or site because of a failure of the same to comply with green or sustainable policies or regulations imposed by the local jurisdiction with respect to recycling or trash collection. Other disputes include referencing carbon taxes or other levies imposed on sites that have not sufficiently complied with similar standards to obtain a green certification, as are taxes designed to disincentivize individual automobile and parking use in favor of mass transit—again, mainly in certain geographic areas or states in the country, though most agree that these concepts will become more prevalent in leases nationwide. Relatively new concepts like these taxes have not yet settled comfortably into being the responsibility of either landlord or tenant.
Furthermore, because the breadth of definition of real estate taxes in a lease, the tenant should clarify—and the landlord will often agree—that real estate taxes do not include federal, state, and local income taxes; franchise and excise taxes; conveyance taxes; inheritance and death taxes; taxes on rent; and any penalties or interest due because of the late payment of taxes by the landlord. The tenant also should seek the benefit of any related tax refunds or rebates that the landlord receives (usually without objection from the landlord).
Insurance. The costs of insurance premiums, too, are sometimes negotiated. Between 2020 and 2023 in particular, many areas of the country saw property insurance premiums sky-rocket—low-lying coastal areas that are prone to flooding immediately come to mind, but premiums have also risen steeply in landlocked states that are prone to wildfires (and, most recently, Hawaii), or tornadoes. In other areas of the country—particularly the West Coast—earthquake insurance, although historically expensive, is more frequently pursued by landlords concerned with the ability of their aging sites to avoid sustaining significant damage when features of the sites are approaching their replacement (or required upgrade) age. Although tenants normally demand that landlords provide standard property and liability coverage for the site, not all have been willing to take on dramatically increased premiums, especially those associated with insurance coverages a tenant may not deem necessary for its own protection. And casualty insurance aside, recent developments in green and sustainable regulations have also become ubiquitous in lease provisions addressing insurance coverages in certain states. For example, costs of endorsements related to the certification of a site in accordance with the EPA’s Energy Star rating and other similar standards. Many tenants—especially those leasing in such a state or locale for the first time—have been reluctant to agree to contribute to the costs of coverage they do not view as directly protecting their interests in the site and premises.
CAM—Allocation and Applicability. Unlike taxes and insurance, Opex charges associated with common area maintenance (CAM) often warrant more expensive negotiation in lease agreements, primarily because it is the broadest of the primary Opex categories. This breadth leaves the potential for all sorts of expenses and services to fall under its extensive umbrella. The term maintenance itself is a source of the inconsistencies that plague leases in their CAM provisions. Tenants, of course, would prefer to define the term maintenance in its most limited sense—that is, being strictly related to causing or enabling a condition or circumstance to continue—the condition or circumstance being the functionality of their premises (and, most likely, only their premises). Landlords, by contrast, are inclined to interpret the term in a broader sense and, if given free rein, would prefer a more expansive definition of maintenance to encompass anything necessary for the premises and site to continue functioning in their current state, and anything necessary for such functionality to continue into the future per potentially evolving (and currently unknown) standards, to preserve the site’s functionality, and profitability. Most landlords would concede that such an overly inclusive definition incorporates most of the maintenance features to which they would ideally require their tenants to contribute.
Another often-contested issue is capital expenditures. Tenants usually succeed in requiring landlords to bear all costs associated with strict capital improvements that are truly made at the landlord’s discretion to add worth to the site. This is for good reason—without such provisions in their leases, tenants might find themselves financing spendthrift landlords’ pursuits of unnecessary extravagances and upgrades from which tenants would not realize a tangible benefit in the short term (or at all). That said, some argue that landlords should not be forced to bear the entire cost of all capital improvements. The tenant and landlord bring different perspectives to this negotiation and the extent to which capital improvements costs are shared varies based on leverage and sophistication of the parties. In the authors’ experience, however, the landlord often can pass along the amortized costs of capital improvements necessary to comply with a change in the law or which are intended to reduce costs. These costs would be amortized over the useful life of the improvement, at a reasonable interest rate. Some pass through, though will be based on the extent of actual, documented savings. Other categories of capital improvements may include the costs of improvements with the purpose of reducing the risk of health or safety to its occupants. There are difficult issues not often addressed in leases, such as how to determine whether something is a capital item or just a repair or maintenance cost—and how to determine the appropriate useful life.
Some Typical Exclusions from Operating Expenses
As discussed above, operating expenses that are passed through to a tenant will include maintenance, operation, and other normal costs of the building. The tenant, however, will negotiate to exclude from operating expenses specific expenses that fall into the general category of landlord’s ownership of the building or site, or arising from defects or landlord negligence.
Within the foregoing general category of exclusions, there are some specific exclusions the landlord almost always accepts that cannot be passed through as CAM or operating expenses. These include depreciation; mortgage payments; leasing commissions; artwork; political contributions; salaries above the level of property manager; ground lease payments; tenant buildout costs for individual tenants; sums reimbursed by tenants or specifically included in rent of other tenants; costs for which the landlord is reimbursed by insurance or other parties; costs in connection with sales, financings, refinancings, or change of ownership; and landlord advertising or promotional expenses, among other items. Some more negotiable exclusion requests (which depend on the leverage of the parties) include landlord’s corporate overhead and general administrative expenses, insurance deductibles or deductibles above a certain amount, reserves, management fees above a capped amount (usually three to five percent of revenues of the building), as well as costs and fees paid to affiliates or subsidiaries of the landlord that exceed competitive or market rates. Some tenants might negotiate what constitutes revenue for purposes of the management fee—for example, whether insurance costs and taxes should be counted as revenue because they do not require much more than writing a check—and require a limitation that the management fees not exceed the cost of similar services provided in the area.
Capital improvements, repairs, and equipment are often part of the discussion of exclusions, and a typical tenant should try to limit the extent to which capital expenditures can be passed through, as discussed in the prior section. In addition, the tenant should try to negotiate exclusions for some related items, including landlord costs to correct structural, design, or engineering defects; legal noncompliance costs with respect to the period before the lease; and costs of environmental compliance or remediating hazardous wastes and materials (except to the extent created or caused by the tenant). The extent to which expenses relate to the parking garage is another area that a tenant might negotiate. The tenant who is likely paying monthly parking fees, for example, and paying an increased management fee because of revenues of the parking garage may resist also having to pay repair and maintenance costs related to the parking garage.
Caps on Operating Expenses
A tenant can reduce the risk of an inordinate increase in operating expenses by negotiating a cap on operating expenses. Providing for a cap of some form on operating expenses also can reduce the need for painstakingly long lists of exclusions from operating expenses. Whether the landlord will agree to a cap is often market-driven and a question of leverage. If raised early enough—usually at term sheet or letter of intent stage—a cap on controllable operating expenses is not uncommon. This cap provides that expenses that are considered controllable by the landlord will not increase more than the cap. There are several issues to negotiate, including the definition of what is a controllable operating expense. The tenant, of course, will request that all operating expenses except real estate taxes, insurance, utility costs, and maybe snow removal are controllable operating expenses and therefore are subject to the cap. The landlord will request a more general (perhaps even vague) definition that would include those items and maybe any other expense the landlord deems not controllable.
Another issue for negotiation is whether the cap limits on a year-to-year basis or is cumulative and compounding. The tenant obviously wants the cap to apply year to year on a noncumulative basis. This means the controllable costs cannot increase from the prior year by more than the negotiated percentage. The landlord will argue that the cap must apply on a cumulative basis, which would allow the landlord to recover any unused expenses in a prior year and apply them to a future year. For example, if the controllable cap is three percent on a cumulative basis, and one year the increase is only one percent, and the next year the increase is five percent, the landlord may carry over the extra two-percent cushion from the first year and therefore the tenant would pay the entire five percent increase (rather than the three percent) in the second year. The landlord will also ask for the cap to be compounding, which means if the first-year cap is at 1.05 the operating expenses of the prior year, the next year the cap of 1.05 would increase by a further five percent, and continue increasing by five percent from the prior-year cap.
Base Year and Gross Up of Base Year. One version of a modified gross lease (sometimes found in office leases) is a lease in which operating expenses are passed along to a tenant to the extent they exceed the amount of operating expenses in the base year (or initial year of the lease). The idea behind this rent structure is that the landlord should be able to predict operating expenses in the initial year and recoup them in the negotiated base rent amount. But over the life of the lease, operating expenses may increase beyond landlord expectations—and the landlord is not willing to rely on negotiated increases in the base rent amount to recoup increased costs (this shifts too much cost risk to the landlord). Accordingly, the base year lease adds an additional layer of complexity to counsel for both sides, and one of the key issues will be whether the selected base year is an accurate reflection of the services and expenses in a typical year going forward.
When the tenant agrees to a base year rent structure, the tenant is intending to pay only the inflationary cost increase in the services and expenses provided in the base year. Of course, if new services are added after the first year, or the level of services is increased and passed through, the tenant will be paying all the cost of the new or increased services, not just the inflationary increase. Terrorism insurance—first required in some buildings after 9/11—when terrorism insurance was not part of tenant expenses in the base year is a historical example of this concern. The cost of COVID protocols first put in place after COVID is a more current example. Tenants with some negotiating leverage may try to avoid these increased costs by negotiating a provision in the lease that allows for an upward adjustment to base year expenses for costs of new services added later. The language might provide that if the operating expenses increase in a subsequent or comparison year due to change in law, policy or practice, then the increase in operating expenses will be included only to the extent of the increase in cost over what the estimated cost for such service would have been in the base year. The landlord, of course, has a similar, but opposite concern—what if base year expenses are artificially high because of extraordinary events like labor strikes or a spike in utility costs? The landlord might add language in a lease to exclude expenses relating to or arising from such extraordinary events.
Free rent concessions in the base year can also lead to an unexpected increase in expenses because free rent could cause the management fee to be understated in the base year. Therefore, the base year amount from the tenant perspective should be calculated without any free rent concessions—or based on the assumption that all tenants are paying full rent, as contrasted with reduced or free rent.
A low level of occupancy in a base year could cause operating expenses in the base year to be below normal, which in turn would cause the tenant to pay an increase in operating expenses because of increased occupancy in subsequent years. A tenant should require that operating expenses (variable operating expenses) are grossed up in the base year to what the expense would have been had occupancy been at the 95 percent or 100 percent level. Of course, a harder question is what constitutes occupancy in this post-COVID period where office employees continue to work remotely part of the time—is it based on the amount of space in a building that is leased or some other measurement that reflects actual use, occupancy, and foot traffic by employees?
One last point—in any base year lease, when negotiating renewals the tenant should consider whether to ask to bring the base year forward to a more current base year. Operating expenses usually increase over time, so not bringing the base year forward may cause the tenant’s share of the increase in operating expenses to be higher than the tenant expected when negotiating the base rent for the renewal term.
Audit Rights. There are some additional rights a tenant needs as a check on operating expenses. As an initial matter, a tenant should obtain copies of the landlord’s operating expenses for several years before the lease effective date as due diligence during lease negotiations. These historical data provide the tenant with a needed baseline to gauge future operating expenses and the types of expenses included in operating expenses. A tenant also needs the right to audit operating expenses periodically. Operating expenses usually are paid on a monthly basis based on the landlord’s estimate of operating expenses for the year. After the end of the year, the landlord will provide notice and a statement of what the actual operating expenses were for the prior year, and the tenant will receive a credit if any overpayment was made, or the tenant will pay any amounts owed if the estimated payments were less than actual expenses. The tenant needs a reasonably detailed statement of the actual operating expenses in the prior year, which should explain why the operating expenses went up or down as compared to the prior year. The tenant must have sufficient time from the receipt of the detailed statement to decide whether to conduct the audit. Thirty to sixty days likely is enough time to make the election and provide notice to the landlord that the tenant is exercising the audit right; provided, however, the tenant needs additional time from the date of giving notice of the audit election to conduct the audit, and taking into consideration the location of the books and records. One hundred and eighty days, or more, would be nice for this.
Negotiators must also consider who can conduct the audit. The landlord will resist any auditor who gets paid on a contingency basis, and the landlord may require an auditor from one of the big, national accounting firms—which would be expensive. The tenant, however, needs to make certain that it has some flexibility in choosing an auditor—perhaps the criteria should just be a CPA getting paid on an hourly basis. The landlord will insist that no audit can occur if the tenant is in default.
The audit provision should make clear that if the audit reveals an overpayment, the tenant will receive a credit against the next additional rent payment due, or a payment from the landlord (especially if the lease has terminated) in the amount of the overpayment. The landlord, of course, will want the ability to dispute the findings of the audit and will want the audit to be kept confidential. If the landlord’s calculation of operating expenses is incorrect—by more than some percentage, say five percent—then the tenant is often reimbursed some of its fees and expenses up to a negotiated, capped amount.
If the lease is a modified gross lease, the tenant needs to conduct an audit of the base year or have a longer period of time to conduct the audit of the base year. Without an audit of the base year, a tenant will not know what services and expenses were included in the base year and will not have all it needs to determine whether or not to decide to audit. The landlord, however, will want the tenant’s right to audit the base year to end at some point—it will need to be able to close the books on the base year and not be concerned that the base year versus comparison year adjustments can be challenged well into the future.
Opex charges can constitute one of the most significant types of rent due under any sort of lease agreement, and any standards or guidelines governing their inclusion or calculation are anything but well settled or universally accepted among landlords and tenants nationwide. The type (but not title) of the lease and its structure, the location of the premises, the features of the site in which the premises are situated, and the relative bargaining power of the parties are all factors that inform the negotiations of the parties on these points. Further, once the type of Opex charges and the methods by which they are determined are settled upon in a lease agreement, the parties then must also ensure that the lease incorporates additional provisions and measures sufficient for each party to be reasonably protected from being saddled with liability for excessively high operational costs. Although this article has attempted to provide a useful introduction to some of the basic concepts to be aware of when negotiating lease provisions addressing Opex charges, the authors note that there remain countless variations and adaptations of the concepts discussed above, many of which are ever-changing. Care should always be taken to ensure that both parties to a lease are completely aware of what Opex charges they will be responsible for; how those amounts will be allocated, imposed, or estimated; and what safeguards are at their disposal in the event Opex charges become excessively burdensome.