This is somewhat of an open letter type of thing basically targeted toward tenants or users as we call them in commercial real estate. In my mind there is a fundamental change in how commercial real estate will do business now and in the future. Disruption. It has happened to the auto industry the steel industry the publishing industry and many more. Commercial real estate is not and will not be any different. The disruption in commercial real estate is what? Simple. The leverage and data that for so long belonged to the owners/brokers in commercial real estate is GONE. It now belongs to the TENANTS.
Tenants have all the leverage now because they have all the money, they are creating all of the jobs, they have access to the same data and locations that we and everyone has access to, they know more about the buildings than we do, from the people who occupied it before, they can verify the information and data online without a commercial real estate source, they will no longer be treated like a commodity with a percentage rider attached. They create the market! This is the new reality of commercial real estate and it is happening now.
Giving away the secrets?
So let’s sit back and imagine that I am having a conversation with a potential tenant and they want to know what I know they already know. Just for fun I let them in on the “transparent truth”. The unfortunate reality of commercial real estate and its recent past and the reality of the commercial real estate future. Details of a lease straight from a broker’s mouth.
Watch Your Ass…Here Is Your Lease.
Rent miscalculations. Inflation of square feet by 25% is not only not uncommon it is standard. Only really able to use 70-90% of the actual space. The space “magically” grows by 20% after the landlord remeasures. Amazing. The elevators, lobbies, janitors closets, air shafts, etc. not only are you paying for that space so is everyone else in the building. How is the building actually measured and who really sets the standard? One landlord I know calls it “gargoyle to gargoyle”. Now that’s a real standard.
Lease Clauses. Operating expense clause allows the landlord to recover out-of pocket expenses….or maybe that’s not all. These clauses can and will be use as a pure profit center for the landlord.
Exclusions. Certain items should be specifically excluded from operating expenses: electricity that serves tenants’ spaces (the landlord recovers this from each tenant individually); executive salaries; consulting fees; market study fees; commissions and advertising costs; initial landscaping costs; structural repairs or replacements; penalties incurred because the landlord fails to pay taxes on time; fees and higher interest charges caused by the landlord’s refinancing of the property; money the landlord must pay if it defaults under a lease or other agreement; any legal fees to resolve disputes involving the landlord; any excessive amount the landlord pays a contractor or vendor because of a special relationship.
Capital improvements. Capital expenditures require particular attention when you’re negotiating a lease. The operating expense clause should exclude them generally from the operating expenses for which you are billed.
Even with exclusion, substantial capital expenditures — artfully relabeled — can find their way into your operating expense bill if you’re not careful. For instance, a lease may require you to pay for equipment rentals. This is a common technique for converting capital expenditures into expenses that are passed on to the tenant. You should agree to pay for equipment rentals only if they’re not a substitute for capital equipment the landlord would otherwise have to buy.
Certain capital improvements, like new, more efficient elevators or a new HVAC system, are supposed to reduce the cost of running the building and thus your portion of operating expenses. Such capital expenditures normally are not included in operating expenses. Landlords often insist, however, that you absorb a portion of the cost. Ask for some demonstration that in fact these capital expenditures will reduce operating expenses. Then if you agree to a lease that allows your landlord to bill you for the annual amortization of these items, make sure your portion is limited to the savings that you realize in a particular year. In other words, your net operating expense should be no higher than it was before the cost-saving installation.
Double dipping. The landlord’s costs of running separate income producing parts of the building should be rolled into operating expenses only after the income is deducted from your operating expenses. This goes for sundry shops, coffee shops, observation decks, and so on. If the building has a garage, your landlord probably charges tenants and the public for parking spaces, but the cost of operating the parking garage may also be included among your operating expenses. If your lease doesn’t specifically exclude this cost, your landlord has a good argument for billing you.
Electricity. For many tenants, electricity is one of the biggest operating expenses. Landlords that want to augment their revenues without quoting a higher rent often use the electricity clause as a profit center, inflating the already substantial cost for this essential service. Don’t let your landlord’s profit unnecessarily increase your utility bills. Typically, leases provide that electricity will be paid for in one of three ways: direct metering, sub metering, or rent inclusion.
Direct metering is straightforward and may be the cheapest for you. When the utility directly meters your electricity, you pay the actual charge for what you use. There’s no question of intervening profit for the landlord.
When only one meter in the building connects to the utility, you or your landlord may install a separate meter to measure the electricity you use. Your landlord pays the utility, and you pay the landlord. This method, called sub metering, can give you cheaper electricity, provided you know what to ask for. If your landlord can buy electricity at low bulk rates, you should bargain for the benefit of that lower rate. Leases often say the tenant will be billed “in accordance with” a utility’s published rate schedule. This may mean the landlord will charge you the highest rate that would apply to your own consumption and pocket the difference.
If a building has only one meter, your electric charges may simply be lumped in with your rent. This method is the riskiest for tenants. The landlord usually estimates your electricity usage by looking at your office equipment and asking how many hours you use each piece in a typical day or week. Such estimates are inherently less certain than measuring the amount of electricity you use. The basic rate landlords charge for electricity could vary as much as 30%.
Be wary of such estimates for another reason. They may include a substantial “safety factor” that needlessly increases your costs. For instance, suppose your landlord pays $2.25 per square foot for electricity but adds $2.75 a square foot to your basic rent. A 10% rate increase would raise your charges to $3.02, and your landlord’s profit would grow from 50 cents to 55 cents per square foot. If your office were 10,000 square feet, that extra 5 cents alone would cost you $5,000 over a ten-year lease term. Your landlord’s profit on your electricity bill: $55,000. And that’s assuming no further increases.
Can the landlord cut off your electricity? Leases used throughout the country often allow a landlord to do it on short notice – leaving a tenant to deal directly with a utility. Making your own arrangements for electricity can be expensive and time-consuming. It may require much interior work , like new risers, conduits, and wiring which, incidentally, your lease may not give you the right to install. Landlords have used such clauses to gain leverage when dealing with unrelated matters.
Avoiding an immediate rent increase.
Base year. Office tenants are generally responsible for increased building expenses and real estate taxes over some base point – either a base year or an expense stop. These escalations can easily outstrip the base rent, and courts will generally enforce the provisions in a lease you sign regardless of how much your rent may increase. So it’s important to understand the mechanics of escalation formulas.
The base year is generally the first 12 months you occupy your space. The expense “stop” is a number representing average, reasonable operating expenses per square foot during those first 12 months. Because it is the lease’s reference point, if you agree to an early base year or an expense stop that’s too low, your landlord will get higher profits every year of your lease. Landlords sometimes argue that the base year should be the 12 months preceding occupancy, but that would mean you’d face a rent increase the day you move in.
If your building has been functioning for a while, the previous 12 months’ operating expenses are a good basis for estimating the expense stop. Check the estimate with management companies that handle similar buildings to see whether your stop is within the normal range. The experience of comparable buildings is also a good source if your building is new or if for some reason you don’t have access to its expense history.
Fair share. Rent escalation formulas, whether tied to direct operating expenses or to indexes should limit the tenant’s obligation to pay a fair share of a building’s total costs. Usually this means you’ll be responsible for expenses in proportion to how much of the building you lease.
Watch out. Some leases make the building’s “rented” area rather than “rentable” area the denominator in the fraction. This means you, not the landlord, would pay operating expenses for the building’s vacant areas. If your landlord adds floors or converts storage or basement space to office space (thereby adding to the rentable area), the fraction used to determine your share of the building’s expenses should reflect this.
Be alert for clauses that don’t clearly spell out how the landlord will calculate your share of the building’s area. Ground-floor space is often more than double the cost per square foot of office space on upper floors.
Indexing the rent. As an alternative to a complex operating expense clause, some landlords index their rents. This lets landlords keep their books private. It also saves tenants from a costly, time-consuming review of expenses that may produce legitimate disagreement.
But be wary. There are a variety of indexes, with many subtle variations in common use, and their behavior can vary substantially. To avoid this predicament, always include a sample calculation in your lease and make sure you understand the implications of any index proposed as the basis for figuring your escalations.
The most common escalation formulas link rent increases to the Consumer Price Index. The CPI measures the cost of food, clothing, recreation, residential rents, and other goods and services, but has no component relating to commercial rents. The components of an index like this may increase far more than the general inflation rate or the cost of running a building.
The CPI-W, a national index, covers only urban wage earners and clerical workers. The CPI-U covers all urban consumers. The CPI-U is generally favored as an index for rent escalation because it covers about twice as many people and is less volatile.
If your city is one of the 28 covered by a metropolitan CPI, your landlord may propose linking your rent to that rather than to the more general CPI-U. But the metropolitan CPIs are much more volatile and, depending on the local economy, may fluctuate in ways entirely unrelated to the cost of running a building
Overlapping escalation formulas. If your landlord indexes base rent in addition to passing through certain operating expenses like fuel, electricity, and real estate taxes, you should negotiate for a partial CPI or porter’s wage formula. Otherwise, you’ll pay twice for those increases.
Don’t over-pay real estate taxes!
In general, real estate taxes are the landlord’s legal responsibility; you become liable only for the taxes you specifically agree to pay. Like the operating expense clause, however, a real estate tax clause can be used as a catchall to cover additional charges.
Limit your obligation to real estate taxes or taxes a community may impose instead of real estate taxes. Your lease should protect you from paying a landlord’s income taxes, corporate taxes, taxes on rents and gross receipts, inheritance taxes, capital gains taxes, and payroll taxes. Be careful about language that tries to make you responsible for undefined taxes that a government authority might impose some time.
Check special assessments to see if they’re included with your real estate taxes: charges for new sidewalks, new sewer lines, and so on. Courts have told landlords repeatedly that special assessments aren’t real estate taxes. If you’re paying assessments as part of your tax bill, you’re giving your landlord more than it bargained for.
In some situations, the landlord will contest high taxes in order to enhance the property’s value. Make sure your lease entitles you to the benefit of any tax reduction your landlord or other tenants may gain after they’ve recouped their expenses.
Hidden costs in the alterations, maintenance & repairs clause.
Alterations. The alterations-and-improvements clause may give you a false sense of security. It may say that you can make whatever nonstructural change you like so long as you get your landlord’s permission, and that your landlord will be “reasonable.” But courts have ruled that things as trivial as lighting fixtures are “structural” components of a building. So a seemingly liberal clause like this could make it impossible for you to move even a single partition.
If you and your landlord disagree about what’s structural, it may declare you in default even if you think the changes you’ve made are reasonable. Consequently, you may be presented with the unpleasant option of paying a big bill at the end of your lease term or restoring so-called structural changes.
So define in the lease what you mean by structural elements. Limit the definitions to components like bearing walls, columns, roof, and façade. And negotiate for the right to make alterations and improvements inside your space, without your landlord’s permission, so long as your changes don’t affect these few structural elements or the systems that deliver electricity and utilities to other tenants in the building.
Maintenance. In a typical multi-tenant office building, the landlord will be responsible for repairing certain listed items – usually structural elements, the exterior, and parts of the building’s common areas. You’re responsible for maintaining and repairing everything in your space.
What happens when something outside your space has to be repaired and isn’t among the items your landlord promised to take care of? You may have to pay for repairs yourself. Either way, you may have no recourse to the landlord, even if the problem makes your space unusable.
Make sure your responsibilities are specified and limited. Your landlord should be obligated to take care of everything you’re not.
Casualties. Many leases have clauses allowing the landlord to terminate the lease after a minor casualty affecting the building, even though your office space remains quite usable. This clause gives the landlord an opportunity to force you out in a rising market or force you to renegotiate unrelated parts of your lease before it will agree to restore the damage.
Make sure your landlord is obligated to restore the building and your space after a casualty if the work can be done in a reasonable time. You should be able to walk if the damage is so severe that your space can’t be restored at all or within a time that’s reasonable, given your business’ needs. Without this right, you could be forced to pay rent even though you have no more office space.
Wear and tear. Your lease should at least stipulate that you’re not responsible for repairing normal wear and tear. Some landlords require tenants to “restore” their leased space when they leave. You shouldn’t agree to such an arrangement. Since almost every tenant has needs that require modification of the space, restoring the space would cost you a lot without substantial benefit to the landlord. Chances are good that much of the restored carpeting, partitions, and so on will be torn out to modify space for the next tenant who comes along.
How to reduce or eliminate a lease obligation
An assignment is the transfer to a third party of all rights and interests the tenant holds under a lease. In a sublease, the transfer usually covers a portion of the leased space or the entire property for a period shorter than the lease term. If your lease says nothing about subleasing or assignments, you’re free to do either. Most landlords, however, are acutely aware of the profit potential this would give you. Usually they’re also concerned about controlling the character and quality of tenants in their buildings. Often the landlord’s lease flatly prohibits a tenant from assigning or subleasing its space. In a variation that is little better, a landlord will permit subleasing only with their consent, and they’ll agree to be “reasonable.”
Subleasing. Flexibility could be crucial to your company in a changing and competitive business environment. Unless you have a tiny space or short lease-term, negotiate for the right to sublease part of your space without the landlord’s approval. This allows you to warehouse unneeded space but gives you the option of easily regaining it from your subtenant.
If your lease requires the landlord’s consent before subleasing and says the landlord must be “reasonable,” define what this means. Prospective subtenants probably won’t wait while you wrangle with the landlord over the terms under which you can sublease. The landlord’s rejection of prospective subtenants should be for limited, objective reasons, like financial inability to handle lease payments or bad reputation. Also limit the landlord’s time to decide on any proposed subtenant. A “yes” that comes too late will cost you a subtenant as surely as a “no.”
Whether you’re required to turn over 100% of sublease profits or only a portion, define sublease profits to make sure your expenses are covered. You should be able to deduct from rents you receive any expenses like advertising, the cost of negotiating and drafting the lease, and concessions like free rent, carpeting and painting, as well as the unamortized cost of your own improvements in the subleased space. Negotiate, too, to deduct rent you pay while your space sits vacant as you try to sublease it. Agree to pay your landlord only when and if you’re paid. If your subtenant defaults, leaving you without a promised income stream, you don’t want to be obligated to pay illusory profit to your landlord.
Some landlords will insist on the right to take back space you want to sublease. This allows a landlord to regain space in a rising market and rent it out itself, perhaps negotiating a longer term with another tenant. If your lease contains a clause like this, make sure the landlord is limited to taking back only the space you want to sublease for the time you want to sublease it.
Assignment. Be especially wary of leases that flatly prohibit assignments or give your landlord unfettered discretion to prohibit one. In many cases, a merger or acquisition will result in an assignment because your lease is transferred to a new legal entity. This means you’d be in default and could be forced out – especially in a rising market. The landlord also may try to impose capitalization requirements on an assignee, demanding, for example, that any potential merger partner have assets at least equal to yours. Yet in a merger you may not be in control. Similarly, your landlord may require that any subsidiary to whom you assign your lease have assets as solid as yours. But subsidiaries are seldom as well endowed as their parent companies. A clause like this seriously hampers your business flexibility, especially if your landlord requires you to remain primarily liable even after you assign the lease, and gives the landlord little more protection.
Make sure you can assign to any subsidiary or affiliate as long as you own at least 33-1/3%; you’re safest to negotiate a deal with no capitalization restrictions on companies with which you may merge. If you think you may be acquired, preserve your flexibility by retaining the right to assign the lease to any acquiring company that meets certain capitalization requirements, for example, that it have a net worth at least equal to yours at the date of acquisition.
Renewals. An extension option can be valuable. Economics aside, it ensures that you can continue operating your business, uninterrupted, at the same location for more than a short three, five, or ten years. If you agree to a fixed rent during the renewal term, both you and the landlord are gambling on a future market. For that reason, leases frequently include a formula – usually tied to the fair market rate – to determine rent during the extended term.
The fair market rate depends on many individual considerations, like a tenant’s credit rating, the formula for calculating operating expenses, and the lease term. If you agree to a fair market value renewal option, specify factors that would be especially important in your case. Moreover, insist that the space be valued for use as office space, even if that’s not its highest and best use” at renewal time.
Quite a few leases don’t require the landlord to commit to the renewal term rental rate until after the term has started. Though the mechanism for determining the renewal rate may be clear, it’s unlikely you’ll want to commit to pay for space unless you know the cost in advance. Make sure your landlord specifies a firm rate far enough in advance to permit you to shop for alternatives. Otherwise, you give up leverage that could help ensure you a fair renewal rate. An ambiguous arrangement has another hidden cost if you do decide to move: you may have to pay steep holdover rates – 1-1/2 to 2 times the normal rent while you shop for new quarters.
Whatever you do, specify the essential terms of your extension option. Don’t postpone the decision with a vague lease clause that “agrees to agree.” This invites costly litigation and could leave you with no office space.
How best to resolve disputes with your landlord
Leases often include a clause saying that in a dispute such items as operating costs, electricity, and real estate taxes, the tenant must pay but can take the landlord to court. This is a bad deal for you. It gives you nothing you didn’t already have, and the landlord has no incentive to settle. Time-consuming and costly litigation may leave you without an answer for years. Meanwhile, the landlord has your money even if the court eventually finds it wrong and orders repayment.
Provide for dispute resolution in the lease. Here are a few guidelines:
* Arbitration may be the best method to resolve disputes like disagreement over the fair market rent or whether a tenant’s use of space has caused more damage than normal wear and tear. Real estate experts are more qualified than the lay public to say who’s right.
* In certain disputes the tenant should have the right to withhold operating expenses – for instance, if the landlord fails to provide essential utilities or repair services.
* The tenant should have convenient access to documentation supporting the landlord’s bills and should be given reasonable time to audit the operating expenses. An independent CPA, not the landlord’s nephew, should prepare the statement.
* The landlord should share certain audit costs with the tenant.
* If it prevails in a dispute, the tenant should get a prompt refund with interest, plus reimbursement for out-of-pocket expenses and attorney’s fees.
Too much information?
Is that too much detailed information for any tenant to have at their disposal? Believe me they can find that information anywhere. Most if not all of the above information came directly from leases and data that I have accumulated and remembered over the years. Without a doubt anyone with the time and a computer could get this information easily and most likely with even greater detail.
Disruption, Transparency, Leverage, Data, Resources. The New Commercial Real Estate Market Reality. Your Thoughts?