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Operating Expenses (Part 2) – Exclusions

Operating Expenses (Part 2) – Exclusions

As stated in the previous blog entry, landlord form leases often allow the landlord to pass through all expenses in any way related to the management and operation of the project.  It is important for tenants to negotiate the charges that can and cannot be passed through.  There are two primary ways for a tenant to protect itself from the unfair pass through of operating expenses: (a) including a cap on increases in expenses and (b) identifying exclusions from operating expenses.

a.  Cap on Increases

Following is a tenant-friendly cap provision:

Landlord agrees that in no event will the total Operating Expenses passed through to Tenant in any year be greater than four percent (4%) more than such expenses passed through to Tenant during the prior year (the “Expense Cap”).  Calculation of the Expense Cap shall be done on a non-cumulative basis.

Almost unanimously, landlords will not agree to a cap on all operating expenses.  Landlords do not want to assume the risk of a high fluctuation in certain costs, such as real estate taxes or utilities.  Accordingly, landlords will insist that the cap only apply to “controllable” operating expenses, which is ambiguously intended as those expenses that can be controlled by the landlord, such as management fees.  Tenants should try to negotiate that controllable operating expenses are limited to taxes, insurance and utilities costs only.

b.  Lists of Exclusions

Following is a sample list of operating expense exclusions for the benefit of the tenant:

The “catch all” (This one in the toughest to get.  It is not a stand-alone exclusion, so make sure to add to the “laundry list” below):

Any management or operating costs in excess of similar costs incurred by reasonable and prudent landlords of comparable buildings in the Phoenix, Arizona metropolitan area.

The “laundry list”:

1.  Any expense that is not specifically enumerated and accounted for as an operating expense in Landlord’s expense statement and/or budget pertaining to the operation and administration of the Project or any common areas (including payroll and payroll-related expenses associated with administration and clerical personnel, general office expenses, and expenses for travel, entertainment, gifts, dues, subscriptions, memberships, tuition, seminars, errors and omissions insurance, automobile allowances, charitable or political donations and professional fees of any kind), and provided that management fees in any year shall not exceed an amount equal to three percent (3%) of the gross rental revenue received for that period.  In no event shall the payroll, payroll related and other expenses related to any employees of Landlord above the building manager or equivalent operational level or not working full-time on the management or operation of the Project be included in operating expenses.

2.  Any items the presence of which will artificially inflate the operating expenses in any year because they are unique, extraordinary or one-time expenses not directly related to the operation of the Project, including, without limitation, such items as special tax assessments and increases in taxes due to governmental modifications (e.g., to split tax rolls).

3.  Any cost in which Landlord is reimbursed by an insurer, other tenant or other third party.

4.  Any overhead and administrative costs not directly incurred in the operation and management of the Project.

5.  Depreciation or amortization of the Project or its contents.

6.  Capital expenditures, including without limitation rental or leasing of capital items.

7.  Costs incurred in preparing space for other tenants or prospective tenants.

8.  Expenses for repairs caused by an act covered by Landlord’s insurance.

9.  Expenses incurred in leasing or obtaining new tenants or retaining existing tenants, including leasing commissions, legal expenses, advertising, entertaining or promotion.

10.  Any fees or costs associated with landlord’s financing, transfer of real estate, or a ground lease of the property on which the Project is located.

11.  Expenses for repair of any item to the extent it is covered under warranty.

12.  Cost of any item or service provided to less than all tenants in the Project.

13.  Accounting and legal fees relating to the ownership, construction, leasing, sale of or relating to any litigation in any way involving the Project, or any common areas, or to the enforcement of the terms of any lease.

14.  Interest or penalties due to the late payment of any expense or tax.

15.  The cost of compliance with any applicable law, including building and fire codes.

16.  The costs incurred in connection with testing, surveying, cleanup, containing, abating or removing environmental or hazardous materials.

17.  Any personal property taxes on Landlord’s personal property not used directly in the operation or maintenance of the Project.

18.  Any costs or expenses related to sculptures, paintings, or other works of art.

19.  The cost of overtime or other expense to Landlord in performing work provided in this Lease to be borne at Landlord’s expense.

20.  All expenses directly resulting from the negligence or willful misconduct of the Landlord, its agents, servants or other employees.

21.  All bad debt loss, rent loss, or reserve for bad debt or rent loss.

22.  Payroll and payroll related expenses for any employees in commercial concessions operated by the Landlord.

23.  Any expenditures made more than eighteen (18) months prior to submission of demand.

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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