If your firm or company leases office space, the odds are good that you pay your landlord for actual annual increases in the cost of running the building. Leases are either set up (1) to include a base amount of operating expenses in the rent (usually equal to the actual total costs in the first year of the lease term) and in subsequent years, the tenant reimburses the landlord for actual costs in excess of that base year amount (“full service”) or (2) to exclude these amounts from rent but allow for separate reimbursement from the tenant for all operating expenses incurred by landlord (“net”).
Whether net or full service, the landlord usually estimates operating expenses for the coming year and the tenant pays 1/12 of that estimated amount each month during the year. After the year ends, the landlord reconciles what was actually spent to operate the building with what the tenant paid over the year. The tenant then either pays any shortfall or is issued a credit for any overpayment against rents coming due.
These reconciliation statements typically arrive at the end of the first quarter and often accounting departments pay them without review. However, in my experience, it is worth taking a little time to do a quick audit of the statement. Here is our approach:
1. If your lease is full service, make sure that the base year reflected on the statement is accurate. Oftentimes a company will add expansion space over their lease term and that space will have a different base year than the original space. Or, if a lease is renewed and the tenant is given a new base year, occasionally the reconciliation reflects the original base year which is lower, resulting in more cost to the tenant. It is worth confirming that all base years are correctly stated.
2. Check “gross ups”. Most leases provide that tenants pay their proportionate share of operating expenses based on their share of the total building square footage. So, if a tenant occupies 40,000 square feet in a 100,000 square foot building, the tenant pays 40% of the total operating expenses for the building.
However, some expenses, like janitorial, are variable. For instance, if 20,000 square feet are vacant in that same 100,000 square foot building, the landlord is not going to pay to have that space cleaned every day; the landlord is only going to pay to clean the 80,000 square feet of occupied space. So, if the tenant pays its pro rata share (40%) of the actual janitorial costs incurred, that tenant is essentially paying for 32,000 square feet of cleaning which is less than the appropriate cost. As such, most leases contain clauses that allow the landlord to gross up variable costs to reflect a fully occupied building.
In reviewing gross ups, make sure expenses being grossed up by the landlord are truly variable. Variable expenses are often specifically defined in the lease and usually include janitorial costs, management fees and utilities which understandably fluctuate with occupancy levels. When we see landlords gross up taxes, we will question it because taxes do not get reassessed each year based on the occupancy rate in a building. Similarly, grounds maintenance should not get grossed up because grounds have to be maintained to the same standard regardless of occupancy levels.
3. Compare last year’s itemized costs with this year’s. Have any expense categories increased by an inordinately large percentage compared to the other categories? If there is not a simple explanation for it, i.e. utility rates increased, it is worth asking the property manager for more information.
4. Are there any new categories of expenses reflected on the reconciliation that were not included in previous years? I had one client receive a reconciliation billing them for “lobby art”. Their lease specifically provided that artwork was a landlord expense and could not be passed through to the tenant so the tenant was able to remove that $20,000 expense from their bill.
5. Is the math correct? Sounds simple but I make mathematical errors regularly and property managers are fallible too.
6. Check for capital expenditures. Most leases do not allow landlords to include capital expenditures in operating expenses unless they increase the operating efficiency of the building thereby decreasing operating expenses over the long term. If your lease has language like this and there is a large capital cost included on the reconciliation, it is worth a friendly call to the property manager to get more information about the nature of the expense.
As our team reviews reconciliations on behalf of our clients, we try to keep in mind the long-term nature of the landlord/tenant relationship; we want everyone to get along over the life of the lease. As such, our approach is always collaborative in nature as we know most overcharges are inadvertent and usually quickly remedied by the property management team. Is there a something I missed? I would love to hear your comments! And, if you would like to download my list of operating expense exclusions, go to this page.
