Today, we venture into the weeds to discuss an event that occurs this time of year.
Nope. Not Chinese New Year – which is cool, by the way.
Instead, we’ll discuss reconciling operating expenses including common area maintenance charges. Fun stuff – huh?
Generally, reconciling expenses proceeds with commercial tenants who do not own their building. Leases, rental agreements or contracts typically outline things such as base rent, commencement, expiration, rental increases and responsibility for mowing the grass and fixing a leaky roof. It’s very important you – or someone within your group – to understand how each of these cost categories is handled.
Typically, leases call for the tenant to pay for expenses related to the operation. If a company occupies a suite of offices, most likely the tenant executed a “full service gross” lease. Similar to other gross leases, an FSG lease lays out a rate inclusive of rent, property taxes, insurance for the premises and general exterior maintenance. What is unique to this arrangement is a charge for utilities and janitorial services which are baked into the monthly check you write.
If you consider a high-rise building with many enterprises, there is often a “pro-rata” sharing agreement for electricity, water, trash and the crew that vacuums the conference room after hours. It would be impractical to contract separately for these services, so most owners don’t. Most will include an “expense stop.” Simply, any of the above is billed to the tenant.
Industrial landlords take a slightly different approach to re-capture costs.
As an occupant of a manufacturing, warehouse, or service building – the tenant’s lease is likely a triple net or an industrial gross lease. The main difference here? Rent with a NNN lease excludes operating expenses from the monthly payment whereas an industrial gross lease lumps them together.
Am I saying no expenses are passed along in a NNN arrangement? Quite the contrary. They are invoiced as they occur or annualized and collected monthly.
So, how does this all play out for tenants?
Each year between October and December, commercial real estate owners budget for the next year. They take into account line items such as rent, property taxes, insurance, and yes, common area expenses like parking lot sweeping, trash collection, landscape maintenance and system repairs.
What might also be considered? Is a vacancy anticipated? Are lease term extensions expected? They’ll also review the current year. Were expenses properly predicted or dramatically overstated? Next, will the gardener charge us more next year? Have insurance coverages been impacted by a hurricane in South Texas?
We know property taxes will increase by 2% unless a change of ownership occurred. Once calculated, a projection of next year, along with those budgeted expenses, is forwarded to the tenant.
You may be wondering, what happens if the owner collected too much money? This is where the February reconciliation begins.
Akin to sending Uncle Sam too many tax dollars, if you paid too much, expect a bonus from the landlord. Conversely, an underpayment will foster a note that you owe more. Please understand, a tenant has full rights to request backup information on items for which the owner seeks payment. A typical scenario would be a request for documentation outlining why wind in Texas would affect a California insurance premium. Or why did tree trimming cost so much?
Finally, the “more on this in a moment” promise. Delve into the terms: base year and expense stops highlighted in full service gross and industrial gross leases. Simply, these clauses limit the amount of common area expenses the owner can recover.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104.
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