Do I Have to Pay for that?

The issue of reimbursable (the technical term is “escalatable”) operating expenses in commercial leases can generally be confusing to tenants. In our first article on this subject, we discussed this concept broadly. Now, let’s dig a little deeper.

When it comes to leases and property expenses, understanding and communicating this concept is critical. Leases address operating expenses the tenant will reimburse to the Landlord, and the same is true for some capital expenses. Is there an easy way for a real estate agent or broker to summarize this to a client so they can more clearly grasp this misunderstood concept?

YES, THERE IS!

It is really important to know how lease language can impact your client financially so you can clearly explain this to them. To start, let’s look at the 2 types of expenses that make up what we call escalatable operating expenses.

#1 – Standard Operating Expenses: the most basic component of escalatable operating expenses. Simply put, they are the out-of-pocket expenses for operating the building, maintaining it, and keeping the systems in-code and up to date. Typically, these types of expenses include property taxes, insurance, utilities, repairs and maintenance, landscaping, cleaning services, supplies, and the administrative costs to handle these details in a competent and professional manner (management office expenses and fees)…anything that contributes to the successful day to day operations of a property generally falls into this category. That then begs the question – What operating expenses would a property have that a tenant should not pay for? Here are the most common non-reimbursable expenses:

• Advertising and marketing expenses to lease vacant space in the property.
• Loan fees and interest payments
• Owner entity fees (CPA fees, tax returns, entity filings, etc.)
• Legal fees to negotiate new leases
• Consultant fees and market studies

#2 – Capital Expenses: the second component of escalatable expenses are some capital expenses that can lower a property’s standard operating expenses. This one is the most contentious issue between landlord and tenant, especially if it is not well documented in the lease as to what constitutes a capital expense that can be escalated. Most leases today allow the landlord to escalate the amortized costs (that is, spread it out over what is known as the payback period) of some capital expenditures that reduce the costs of operations. The contentious part is – does the lease require documentation to verify that actual reductions in operating expenses were achieved, or just that it was intended to reduce operating expenses? In our estimation, the main objective of this concept is to include capital improvements that are incurred to exclusively reduce operating expenses over a period of time (the amortization or payback period), not  to replace an asset or escalate capital repairs because it is beyond its useful life. Newer equipment is typically more efficient and will have less costs of operating it due to newer technologies. This tends to be viewed as incidental efficiency, which tends to fall outside the intention of what is allowed. Here are some examples of capital expenses that can provide actual, documented operating expense reductions:

• LED lighting retrofits (lower electricity costs)
• Sensor controlled plumbing fixtures (lower water and sewer charges)
• Installation of an EMS (energy management system)
• HVAC capital improvements/upgrades that specifically lower energy use

We know how complex commercial real estate leases can be. Keen handles the details and complexities that are negotiated in leases every day. Please feel free to reach out to us with any questions.

In commercial real estate, expertise matters.