Operating Expense Mistakes

Each year, landlords prepare and review building operating expenses for reconciliation and tenant expense pass through.  As costs generally tend to rise, occupiers of space are the ones who suffer, as landlords are able to pass through the majority of controllable and non-controllable expenses.  In a large multi-tenant office building, each tenant has different leases and terms relating to operating expenses.  With leverage and good tenant representation, many leases will include caps on controllable operating expenses, expense stops, exclusions, and language to hold the landlord accountable in their accounting practices.  Given the variations of language and often a lack of effort and sophistication by property management, inevitably, there are errors made.  Even the most sophisticated and large landlords across the country often make costly mistakes.

The four areas where landlords most often make operating expense accounting errors are:

1. Energy Expenses: Landlords are often found over or double charging tenants for energy use.
2. Management Fees: It is important to cap management fees and have language regarding typical market rates. If the lease says 4%, the rate will most certainly be 4%, even if the market rate is 2% or 3%. This is especially important to review if the landlord and/or landlords company also manages the building.
3. Tenant Reimbursables: There are often expenses that landlords are able to capture reimbursement for. For example, after hours HVAC, whereby the tenant reimburses the landlord for the use.  The landlord needs to back those reimbursable expenses out of the buildings operating expenses.  Instead, landlords often simply include those reimbursable expenses in the pass through, thus “double dipping”.
4. Gross-Ups: Many leases will have a gross up provision, meaning that if the building is less than fully occupied, the operating expenses will be calculated and passed through as if it were fully occupied. Landlords and their property managers often fail to gross up the occupancy and therefore are overcharging the occupants in the building.

How can a tenant combat this?  The short answer is leverage.  Larger tenants will have more leverage to negotiate favorable operating expense provisions.  This becomes even tougher in a landlord driven market, which most cities across the country are experiencing in 2018.  Placing caps on controllable expenses is key, but the most important provision is the right for a tenant to have annual, retroactive, contingent based audit rights.  These audit rights will hold the landlord accountable and provide recourse when and if mistakes are made.

Make sure your broker is informed and persistent enough to pursue these important lease provisions.  With competition placing growing pressures on closing deals, we often find even the largest and best-known firms and brokers can fail to adequately protect their clients in the area of operating expenses.