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Helping Your Bottom Line: Hidden Costs Under Your Lease

11/2/2016 | Articles & Alerts

Many businesses enter into a lease for their office, industrial or retail space without really knowing the potential costs that could be charged under the lease. You have likely gone to great lengths to negotiate a fair base rent, but have you considered the economic impact of other lease provisions? In most commercial leases, tenants are obligated to pay a share of operating expenses, real estate taxes and the landlord’s insurance premiums. While landlords have little control over real estate taxes and insurance premiums, most leases provide landlords with considerable latitude to determine what can be included in operating expenses.

You may be surprised to learn that many leases allow landlords to pass through capital expenditures such as a roof replacement or the repaving of an entire parking lot. These expenses, by their nature, are often very large sums that will ultimately affect your bottom line. In addition, operating expenses will often include a property management fee ranging from two percent to five percent of the rent. In some instances, landlords charge both a management fee and the salaries and benefits of their employees, which in effect doubles the management costs that are passed through to the tenant. There are numerous other miscellaneous expenses that are passed through to tenants. However, with little incentive to control these costs because the landlord is simply passing these costs on to its tenants, operating expenses almost always increase from year to year.

To protect yourself, when negotiating a lease or a renewal of an existing lease, you should insist on a non-cumulative cap on “controllable” operating expenses. “Controllable” operating expenses generally include all operating expenses, other than taxes, insurance, utility costs and snow removal charges. If pushed hard enough, many landlords will agree to a five percent annual cap. The key here is that the cap is calculated on a non-cumulative basis (i.e. the tenant’s share of operating expenses will not increase by more than five percent over the tenant’s share of operating expenses in the previous year). Landlords may agree to a cap on the condition that it is calculated on a cumulative, compounded basis. However, under this approach, what may look like a five percent cap could be substantially higher in future years.

While a cap on expenses provides some protection from “landlords gone wild,” it is important to make sure that operating expenses are carefully defined and appropriate exclusions from operating expenses are spelled out in the lease, including exclusions of capital expenses (or at least certain types of capital expenses) and limits on management expenses. Bottom line: help your bottom line by being diligent when negotiating operating expense provisions in your lease. In this economy, you have more leverage than you may realize.