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Commercial Real Estate Operating Expenses

As commercial real estate experts, we’re always looking for ways to help people like our clients, so we thought it would be helpful to share a guide about the topic of operating expenses as it pertains to commercial tenants.

To start, operating expenses – which are sometimes referred to as nets – are the costs associated with maintaining and managing a commercial property, and there are three of them:

#1. Property Taxes: Property owners are required to pay real estate taxes to the government, so often these taxes are then passed along to the tenants. It’s essential to define “real estate taxes” in the lease to exclude income taxes, franchise taxes, and personal property taxes, which should not be passed on to the tenant. Most leases include these exclusions, or landlords are typically willing to revise the lease to incorporate them.

#2. Insurance: Landlords need to maintain insurance on the building, as required by their lenders. The cost of this insurance is also often passed through to the tenants.

#3. Common Area Maintenance Charges (CAM): These charges cover a variety of maintenance and overhead costs for the shared or public sections of the property. These can include maintenance and repairs, administrative fees, utilities for the common areas, building amenities, landscaping, and parking lot upkeep. The specific items included in CAM charges can vary by property type and owner, and typically the larger the common area or shared space, the greater these charges will be.

Now, who is responsible for these costs will actually depend on the structure of lease a tenant signs. Check out our guide here for more information on lease types.

In summary, a commercial tenant will have the operating expenses included with the base rent if it is a gross lease, or if it is a net lease, the tenant will be charged for operating expenses separately. However, there are hybrids of the two, such as a modified gross lease.

So, what is generally not included in operating expenses? Well, operating expense exclusions are often highly negotiated in leases; however, these items can typically be removed from the tenant’s responsibility:

• Capital expenses (big property projects, such as roof replacement)
• Administrative and personnel salaries
• Debt service
• Advertising and marketing costs
• Leasing commissions
• Costs arising from gross negligence or willful misconduct by the landlord or its agents
• Costs to comply with laws to remedy pre-existing conditions (such as the removal of hazardous materials)
• Tenant improvement costs or costs for services only for other tenants
• Legal fees for disputes or lease negotiations between the landlord and other tenants
• Capital reserves for future repairs or for future tenant improvements

Lastly, what can a commercial tenant do to minimize costs and protect themselves? Well, first a tenant should hire a good real estate attorney and listen to their tenant representative to guide them throughout the lease negotiation and reviewing process. Next, there are a few more measures to take:

REQUEST A BASE YEAR LEASE
Unfortunately for the tenant, the landlord will dictate the lease type and use their template, but a tenant can request using the concept of a “base year.” This is when the tenant only pays their proportionate share of increases in operating expenses from year one. In other words, rather than paying 100% of the operating expenses each year, the tenant only pays the difference between the operating expenses in the base year and the current year. For instance, if 2023 is the base year, and the operating expenses are $8.00/PSF, then in 2024, the operating expenses are $8.20/PSF, the landlord will charge the tenant $.20/PSF. This will continue throughout the lease term.

NEGOTIATE OPERATING EXPENSE EXCLUSIONS
Additionally, going back to the excluded items from operating expenses, landlord-oriented lease templates typically don’t list many exclusions, or they just state a general description of operating expenses. Landlords may have limited flexibility to grant tenant-requested exclusions, especially if these exclusions are inconsistent with the building’s existing accounting practices or other leases in the building. Negotiating exclusions from operating expenses can be one of the most time consuming and contentious areas of lease negotiations, but the effort can result in significant savings for the tenant and reduced disputes for the landlord.

ASK FOR AUDIT RIGHTS

Tenants should also consider negotiating for the right to audit the landlord’s books and records related to the operating expenses passed through to them. This right allows tenants to verify that the expenses they are being charged do not include excluded items. Typically, audit provisions will include a deadline for the tenant to notify the landlord of their intention to audit after receiving an expense statement and a deadline for completing the audit. If an audit reveals that the tenant was overcharged by a certain percentage (e.g., 3-5%), the landlord may be required to cover the tenant’s audit fees. Due to the sensitivity of financial information, audit provisions are often heavily negotiated.

BUDGET

Lastly, once the lease is signed and the operating expense responsibilities are determined, the tenant needs to budget accordingly. Landlords and property managers should have historical operating expense data to share, so the tenant can make a good prediction of how much the operating expenses will be now and how much they will increase over the lease term.