Operating Expenses in Office Leases

When an office tenant seeks to rent a space, comparing various options can be perplexing. This is because, aside from the initial rent, office buildings have distinct payment structures to cover their operating expenses, also referred to as Opex. In this article, we will examine the definition of operating expenses and the different methods landlords use to manage 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 invests $1 million to upgrade an HVAC system expected to last for 10 years. This system will also result in annual savings of $200,000.

If we set aside the time value of money, the tenant would need to repay the landlord $200,000 annually for 5 years to cover the landlord's initial $1 million investment.

However, leases typically consider the time value of money. For example, with a prime rate of 5%, $200,000 in the second year is equivalent to $181,406 in the first year, and $200,000 in the third year equals $172,768 in the first year, and so on.

Frequently, leases will use the prime rate of a major 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 demonstrated in the example above, the Landlord would earn $39/SF regardless of any increase in operating expenses.

However, the Landlord might argue that the $39 earned now would be worth less in the future. Therefore, it is common for the Landlord, when preferring the increase over a base year, to also seek a "rent bump" every 5 years.

In the example above, the rent in year 6 rises to $70/SF for the remainder of the lease. This increase enables the Landlord to earn a higher rent than in the first five years of the lease.

Combination

At times, landlords may request an annual percentage increase in the base rent, along with the payment of operating expenses beyond a base year and a rent increase.

The key thing to keep in mind is that there are no fixed rules. No lease structure is unchangeable, and while certain conventions are more prevalent, it is ultimately up to the market participants to determine what they are willing to accept based on their available options.

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.