Lease Cost Matrix and Occupancy Cost
When comparing different properties tenants all want to know the total occupancy cost. Competent agents provide rents and expenses then do a comparative analysis of these costs. When we look at occupancy costs, we evaluate base rent, concessions, improvement costs and tenant other tenant driven costs and compare these options using simple spreadsheets to complex analysis software. Some clients want to look at annual costs, some want a net present value of costs, either way the information is available and we encourage clients to understand these costs before signing a lease. And remember, the defined expenses in the lease should relate to the projected and historical expenses presented by the property owner.
It all comes down to occupancy cost.
The majority of office leases in our community are full service gross and operating expenses are charged as a pass through rent over a base year. In fully serviced office leases operating costs are included in the first year’s base rent and changes in operating costs are reconciled each year against a base year. In some markets landlords charge rent on a NNN basis. That means operating costs are paid each month as a pro rata share or percentage of the property leased. Compared to fully serviced or gross leases, operating expenses are a mix of taxes, insurance, common area maintenance and direct expenses controlled by the tenant like utilities. The important thing to note is expenses are not free. Either you pay them directly in a NNN lease or indirectly in a gross rent with changes in the expenses applied over a Base YearLease Types Explained
Not all leases are equal, but operating costs when comparing the different lease types can be equivalent or very similar. The first table [fig 1-1] to the right shows the different types of leases: NNN, Industrial Gross, Modified Gross, Fully Serviced. We categorize expenses and compare how the costs are segregated. In the next table [1-2] we give a mathematical example how the costs segregated add up to the same occupancy cost.
Industrial Gross Error
Many agents quote Industrial Gross as net of Janitorial and Electricity/Gas, but rent could also exclude HVAC maintenance, water, and garbage.
Be sure to ask.
So what goes into operating costs?
Base Rent—this is the rent a tenant pays and is clearly stated in a lease. Real estate agents will quote this rent. Often we create a schedule to reference in the lease document to eliminate discrepancies or misunderstandings during the lease term. In some instances rental increases can be based on the Consumer Price Index (CPI). Make sure the CPI has a base year and a metropolitan statistical area (MSA). These are important so the correct increase can be applied. For example SF/Oakland MSA 2010=100.
Base Year—the base year is the year which the operating expenses are compared. For example if the lease is executed and the tenant moves in the property say in May of 2016, the base year would be 2016. In our market the base year is tied to the year the tenant takes possession of the premises; if possession is in the 4th quarter of the year most landlords will move the base year to the next year.
Comparison Year—the comparison year is the year which we compare expenses against the base year. In fig 1-3 above we show how the math is calculated. Under Gross Leases the tenant is responsible for differences in the base year and comparison year costs. We often refer to these as expense “pass throughs’, because the cost is passed through to the tenant. Operating costs do not always go up, some comparison year operating costs are lower than the base year, and the tenant is not supplied a credit. In the example above the comparison year fluctuates but at a cost higher than the base year. Tenants are supplied credits if they over pay for estimated or projected operating costs in a comparison year. The credit is applied in the next comparison year.
Pro Rata Share—this is the percentage of rented space to the total property or project [see fig 1-4]. Pro rata shares are important for tenants and owners to portion costs as a percentage of occupancy. In NNN leases tenants pay their share of total operating costs as a direct expense. In gross office leases the pro rata share is applied for the difference in total operating costs.
Other terms you may hear:
Some properties have a specific cost as the base instead of a cost during a specific year. If the cost to operate the property exceeds the base stop the tenant pays the difference. Only Bishop Ranch uses this method. We don’t see this too often in our market.
If you want to learn more about Expense Stops this article goes into more detail (Click Here)
Replacement of structural elements like roof, parking lots and HVAC systems. Major repairs or mandatory code upgrades like handicap walkways and restroom remodels.
Not all capital items are bad. Sometimes Landlords can do improvements which save on operating costs and the savings are rebated back to the Landlord. What usually is not included in operating costs are common area improvements that are structural in nature, a tenant improvement, or any improvement with a useful life over 5 years unless it is amortized over its useful life. What we don’t like seeing are capital projects expensed in one year at a big cost to the tenants. Items classified under 5 years are typically HVAC equipment or lighting and these acceptable to expense in the year of the cost. Some agents try to eliminate all capital costs from leases, we think this is a mistake, some costs are necessary to the smooth operation of the property and as long as the manager is consistent with their approach, Tenant will see modest increases.
We like landlords to maintain expenses in their operating costs and build reserves. It means that the landlord is considerate of the property and the inevitable replacement of major components. As HVAC equipment gets older the cost to maintain it goes up. Building a prudent reserve allows both the property to replace or repair capital items routinely and keep the property in good condition. Prudent managers will competitively bid vendors every couple years. They will establish a capital budget and understand the remaining useful life of the building components and keep a reserve. Doing this keeps expenses as level as possible.
These are those costs typically contracted by the Landlord. Obviously there are market forces for any expense. In 2000 we saw electricity costs in California double and after 9/11 insurance rates went up. Controllable is a very subjective term. Often we are negotiating a 3-5% cap on controllable expenses. Some owners will agree to an annual cap above the base and some want a cumulative cap. Either way, know that cap of operating expenses are subject to market forces and are not always negotiated in leases.
