Operating Expenses in Office Leases
Updated: Nov 12, 2024
When an office Tenant is looking to rent an office space, comparing different options can be confusing because apart from the starting rent, office buildings have different payment structures to account for their operating expenses also known as Opex. In this article we will review the definition of operating expenses and the few ways Landlords deal with them.
Operating Expenses
Operating expenses are the costs associated with maintaining the operation of an office building. Among others, these costs include the following:
a) Administrative (i.e city requirements and accounting)
b) Security
c) Advertising
d) Repair & Maintenance (i.e lighbulbs )
e) Contract Services (i.e the elevators that need to be inspected every year)
f) Janitorial Services
g) Insurance
However, the devil is in the details and it is important for a Tenant to delineate the definition of "Operating Expenses".
For example, a Landlord would prefer if the mortgage payments on the office building and the leasing expenses were included in the operating expenses. However, these expenses do not benefit the Tenants. In fact, expenses that should be included are the ones only pertaining to the operation and maintenances that are common for similar buildings and that benefit all the Tenants.
Another point of contention are the capital expenditures. Usually, these are expenses that are outside of the normal day to day operation of the building. For instance expenses to replace or upgrade the mechanical, electrical, plumbing or HVAC systems are capital expenditures. Additionally, capital expenditures also include for example, renovations of an office building.
Usually in an office lease, it is important that:
a) The capex should be amortized over the useful life of the equipment.
b) The Tenant does not pay for capex aiming at renovating a building and for capex aiming at complying with a law.
c) For capex that leads to savings in expenses, they should be included in operating expenses to the extent of the actual savings achieved by such expenditures.
To illustrate point c), let's look at a concrete example:
A Landlord spends $1M to upgrade an HVAC system that is expected to last 10 years. Also, the HVAC system will lead to a saving of $200,000/year.
Before complicating the issue, let's forget about the time value of money. In this case, the Tenant would need to pay back the Landlord $200,000 for 5 years until the Landlord is reimbursed his initial investment of $1M.
However, usually leases will take into account the time value of money. More concretely, in the example below, based on a prime rate of 5%, $200,000 in year 2 equals $181,406 in year 1 and $200,000 in year 3 equals $172,768 in year 1 etc.
Finally, often time, leases will use the prime rate of a large bank as the discount rate.

Annual Rent Increase in Lieu of the Operating Expenses
This is the simplest scenario. In this case, the rent increase by a percentage every year. That percentage is often time 3% but it can vary.
Below there is a hypothetical case of a space that is 10,000 SF and of the yearly starting rent of $65/SF.
The percentage increase offers predictability both for the Tenant and for the Landlord. Usually the Landlord will justify this increase by talking about the inflation.
Increase in Proportional Share of Operating Expenses over Base Year
The second way to deal with Opex for a Landlord is to charge the Tenant an increase over the first year of the lease.
Example

As it can be seen in the example above, the Landlord would net $39/SF regardless of of the operating expenses increase.
However, the Landlord would rightly point out in this scenario that the $39 he would earn would be worth less in the future. Thus, it is often the case that when the Landlord favors the increase over a base year, he also wants to increase the rent by a so called "rent bump" every 5 years.
In the example above, the rent in year 6 becomes $70/SF until the end of the lease. This increase allows the Landlord to net a higher rent than on the first five years of the lease.
Combination
Sometimes, landlords will ask for a yearly percentage increase in the base rent and the payment of the operating expenses over a base year and a rent bump.
The most important point to remember is that there are no rules. No lease structure is set in stone, and although some conventions are more common than others, ultimately, the market participants will decide what they are willing to accept based on their alternatives.
Conclusion
When looking for a new office space in NYC, it is important to understand how each Landlord deals with the operating expenses. In fact, knowing how the rent will increase is just as important as the asking rent. Without understanding the different rent increase structures, it is not possible to make a reasoned opinion about the best lease alternative.
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