COVER STORY, OCTOBER 2006

DON’T LET LEASE LOOPHOLES DRAIN PROFITS
Six ways for office landlords to watch the bottom line.
Susan Halsey

Although practices can vary from market to market, rents for office properties are commonly quoted on a full-service basis. A rent rate is negotiated, a base year is determined and tenant is required to pay its proportionate share of the increases in the total expenses necessary for the maintenance and operation of the building in each calendar year following the base year. This structure poses more drafting challenges for a landlord than the triple-net form of lease more commonly used for industrial properties. In a triple-net lease, the landlord receives a monthly rent payment net of expenses for taxes, utilities and insurance, which are completely passed through to the tenant in the base year and every year thereafter. Tenants under triple-net leases are usually required to perform all maintenance and repairs at the property, leaving landlord with no other required expenses of operation. As a result, the landlord can calculate his revenue from the lease without concern that increased expenses over the length of the lease term will erode his profits.

The potential traps for the full-service landlord arise in connection with determining the types of expenses to be included and excluded from the definition of operating expenses allowed to be passed through to the tenants. The typical lease contains a very broadly drafted provision defining operating expenses as all costs and expenses incurred or accrued in connection with the ownership, operation, management, maintenance, repair and protection of the property. Such provisions will also usually include a laundry list of specifically allowed expenses, such as management fees, janitorial costs, landscaping costs, property and liability insurance premiums, real estate taxes and utility charges. During lease negotiations, tenants will often try to revise the definition of operating expenses to exclude a list of expenditures as long or longer than the landlord’s list. The following issues should be carefully considered because the landlord’s failure to appropriately address these items in the lease can result in lower profits:

• Operating expenses should specifically include expenditures required for compliance with applicable laws, including license, permit and inspection fees, and attorneys’ fees and court or other dispute resolution costs, incurred in contesting real estate taxes or the validity and/or applicability of any governmental enactments which may affect operating expenses. A tenant will argue that the landlord should be providing the tenant with premises that are already in compliance with laws and that, therefore, the provision should be deleted. But doing so will create a loophole in the lease leaving the landlord responsible for future compliance with new laws enacted later in the lease term and legal fees for disputes and actions which benefit all tenants of the property. The provision should be left in the lease even if landlord has to agree to include only the costs of compliance with laws enacted after the date of the lease.

• Since the lease will most likely contain a provision specifically including premiums for property and liability insurance carried by the landlord, a tenant will seek to exclude costs for repairs, replacements and general maintenance covered by insurance proceeds (or which would have been covered by insurance proceeds had landlord maintained the insurance required to be maintained by landlord under the lease). Although this seems to be a reasonable request, the loophole is that the cost of a repair may be “covered by insurance”, but the landlord will not receive the full amount of the repair cost from the insurance company. In order to allow full pass through of repair costs, the lease should specifically include all deductibles under insurance policies carried by landlord covering the property and any self-insured retention amounts. The landlord could also avoid this trap by replacing the phrase “covered by insurance” with the phrase “actually paid by insurance”.

• Real estate taxes are typically passed through to tenants as an operating expense, and are often defined as “property taxes, assessments, fees, levies, charges and other taxes of every kind whatsoever, general and special, which may be levied or assessed against or arise in connection with ownership, use, occupancy, rental, operation or possession of the property, or substituted, in whole or in part, for a tax previously in existence by any taxing authority, or assessed in lieu of a tax increase.” The tenant will want to insert an exclusion for the landlord’s income, franchise and estate taxes because they relate to the landlord’s business rather than to the building. However, the new margin tax recently passed by the state legislature will replace the old franchise tax system. Agreeing to the tenant’s request would result in the inability to pass this new tax through as an operating expense even though it was arguably assessed “in lieu of a tax increase” or “substituted for property taxes previously in existence” (since it was passed with a simultaneous reduction in property taxes).

• Tenants will object to the inclusion of costs for capital expenditures because they result in improvements to the landlord’s property. Nevertheless, the landlord should include in operating expenses an amortized amount of all capital expenditures incurred (a) to conform with laws, or (b) with the intention of promoting safety or reducing or controlling increases in operating expenses (such as lighting retrofit and installation of energy management systems). While a request to limit the included capital expenditures to those necessary to comply with laws enacted after the date of the lease seems reasonable, this could create a problem for a large building owner with an annual or ongoing replacement program for compliance with laws such as the Americans with Disabilities Act (ADA), for example. Such budgeted costs for ADA compliance would be included in the operating expenses incurred in the base year and should therefore not be objectionable to tenant.

• Operating expenses should exclude electrical services used in the operation, maintenance and use of the property. Instead, the lease should contain a provision requiring tenant to pay its prorata share of such costs in addition to other rental amounts. By removing the electrical costs from operating expenses and establishing a separate obligation, the landlord can pass all of such costs through to tenants in the base year rather than being limited to a pass-through of the excess of such amounts over the base year costs.

• Many tenants will request that the landlord agree to place a cap on increases to tenant’s proportionate share of operating expenses. If the agreed upon cap is too low, the landlord will be responsible for the additional expenses. The landlord can minimize this risk by agreeing to cap only the expenses which are controllable. In years past, the only expenses considered to be uncontrollable were taxes, utilities and insurance. Nowadays, a savvy landlord will also exclude from “controllable expenses” security costs and increases to minimum wage laws, collective bargaining agreements or other similar legal requirements. Another way to reduce the problems associated with granting a cap, is to provide that the cap will be calculated on a cumulative and/or compounding basis so that the cap actually increases each year. The landlord can also insist that any increases in operating expenses not recovered by landlord due to the application of the cap will be carried forward into succeeding calendar years during the lease term (subject to the cap) until fully recouped by the landlord.

Although there are numerous other areas in an office lease that require a landlord’s attention, successful negotiation of the six issues discussed above will enable landlord to minimize reductions in revenues due to the inability to recoup expenses from tenants.

Susan Halsey is a partner and chair of the real estate group with Jackson Walker LLP in Dallas.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.