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Operating Expenses (Part 1) – Introduction

Operating Expenses (Part 1) – Introduction

This blog entry is the first in a three part series on the negotiation of operating expense provisions in commercial leases.

1. Introduction

Landlord form leases typically have the following language:

Tenant shall pay its proportionate share of Operating Costs for the Project as additional rent.  Operating Costs shall mean any and all costs, expenses, and fees incurred by Landlord in owning, managing, maintaining, repairing and operating the Project (whether or not now customary or in the contemplation of the parties), including, but not limited to, the following… [insert exhaustive list of potential expenses].

This language is broad and allows the landlord to pass-through any and all charges that could in any way be related to the project.  In my practice, I have seen tenants accept this language without modification using the following rationalizations: (1) the landlord will pass-through the same charges to all tenants, and the landlord will not want to face the wrath of all unhappy tenants with excessive charges, (2) the landlord relies on tenants remaining at the property and renewing their leases and will be fair, and (3) the landlord provided historical data showing acceptable annual increases in operating expenses for the project and the pattern will likely continue.

There is some small value in these rationalizations.  Landlords do not want to establish a reputation as price gougers for future tenants, nor do landlords want to constantly fight with tenants over charges.  However, the increase of vacancy and default rates has made landlords desperate and deviate from best practices.  Landlords are not necessarily greedy and lining their own pockets.  In addition to trying to keep projects afloat and meet loan obligations, landlords are trying to keep jobs for their long-term employees.  This has caused landlords to evaluate every method for cost savings… and cost exploitation.  In fact, I know of a few nameless landlords that have shifted employees to property management for the sole purpose of analyzing what costs could possibly be passed through to tenants under their leases.

For example, I recently handled a matter for a tenant that paid roughly ¼ of the operating expenses for a building.  After several years at the building, the tenant received a bill for 2009 operating expenses that included new expenses that had not been passed-through in prior years: the full salaries of a security manager and building engineer.  This was in addition to other findings from an audit by the property management staff showing alleged undercharges for utilities and janitorial services.  The undercharge amount was over $100,000 and, according to the terms of the lease, due within ten days following receipt of the invoice from landlord.  The tenant must pay or risk being in default.

Provisions on operating expenses (also called additional rent, CAM charges, operating costs, etc.) should be appropriately negotiated.  The next two blog entries will focus on: (1) limitations on the types of charges that may be passed-through to the tenant, and (2) audit rights for the tenant to verify that the charges passed-through under the lease are warranted.

Prior to using any language or concepts from this blog entry, consult with an attorney.

Ryan Rosensteel is a real estate and construction attorney licensed in Arizona.  You can contact him at ryan.rosensteel@azbar.org.

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