allocating operating expenses in commercial real estate

Allocating Operating Expenses in Commercial Real Estate Leases: Negotiating Strategies for Landlords and TenantsStructuring Pass-Throughs, Exclusions, Gross-Up, Expense Cap, and Other Provisions in Net Leases and Structuring Gross Leases

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Hannah Dowd McPhelin, Partner, Troutman Pepper, Harrisburg, PA

Julia E. Tomec, Partner, Troutman Pepper, Philadelphia, PA

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Allocating Operating Expenses in Commercial Real Estate Leases: Negotiating Strategies for Landlords and TenantsHannah Dowd McPhelin, Esquire Julia Tomec, EsquireJune 10, 2021

Allocating Operating Expenses in Commercial Real Estate Leases

Introductions Plan for Today:

- Overview of Lease Structures- Standard Inclusions and Exclusions- Gross-Up Provisions- Expense Cap Provisions- Tenant Audit Rights- COVID-19 Considerations

Please feel free to submit Questions during Program as well as during Q&A Session

Introduction

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Start with parties’ expectations as to who does what (consider property type and geographic differences)

Net Lease (Triple Net or NNN)- Base Rent plus charges for Tenant’s share of common area maintenance costs (a/k/a

CAM, OpEx), landlord’s insurance costs and real estate taxes (sometimes utilities).- Base Rent plus Tenant performs and pays for everything else

Base Year- Base Rent plus charges for Tenant’s share of any increases in common area

maintenance costs, landlord’s insurance costs and real estate taxes over the “BaseYear.”

Gross- Typically Base Rent plus utilities.- No additional charges for common area maintenance costs, landlord’s insurance costs or

real estate taxes.

Lease Structures – General Overview

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Tenant pays its share of common area maintenance costs, landlord’s insurance costs and real estate taxes for the building.

Sometimes insurance costs and/or utilities are lumped in with common area maintenance costs or operating expenses.

Primarily negotiating:- Inclusions and exclusions for operating expenses;- Caps on operating expense increases;- Caps on management fees;and- Inclusions and exclusions for real estate taxes.

Lease Structures – Net Lease

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Tenant pays its share of increases in common area maintenance costs, landlord’s insurance costs and real estate taxes over the “Base Year” costs

Which year should be the Base Year?- Calendar v. fiscal v. other- Different Base Years for CAM and Real Estate Taxes

Base Year’s cousin: the Expense Stop Negotiating similar provisions to Net Lease (prior slide)

Lease Structures – Base Year

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Typically, the Tenant only pays Base Rent and its utilities (sometimes utilities are included).

No additional charges for common area maintenance costs, landlord’s insurance costs or real estate taxes.

Sometimes “modified gross” will include a charge for Tenant’s share of real estate taxes in addition to Base Rent and utilities.

Don’t have to negotiate inclusions/exclusions or caps on charge increases.

Lease Structures - Gross

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“Including but not limited to”- Tension between Operating Expenses and condition of Property- Worth the fight to add Operating Expenses must be reasonable?

Exclusions:- Leasing commissions, attorney’s fees, costs, disbursements and other expenses incurred

in connection with negotiations for leases with tenants, other occupants, or prospective tenants or other occupants of the Building, or similar costs incurred in connection with disputes with tenants, other occupants, or prospective tenants, or similar costs and expenses incurred in connection with negotiations or disputes with consultants, management agents, purchasers or mortgagees of the Building

Standard Inclusions and Exclusions

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Exclusions:- Costs of the initial construction of the Building and repairing, replacing or

otherwise correcting defects (but not the costs of repair for normal wear and tear) in the construction of the Building, the tenant improvements, the parking garage or other improvements comprising the Building, or in the Building equipment

- Allowances, concessions and other costs and expenses incurred in completing, fixturing, furnishing, renovating or otherwise improving, decorating or redecorating space for tenants (including Tenant), prospective tenants or other occupants and prospective occupants of the Building, or vacant, leasable space in theBuilding

- Payments of principal and interest or other finance charges made on any debt and rental payments made under any ground or underlying lease or leases, except to the extent that a portion of such rental payments is expressly for ad valorem/real estate taxes, interest charges and increased property as a result of such action


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- Costs incurred in connection with sales, financing, refinancing, mortgaging, selling or change of ownership of the Building, including brokerage commissions, attorneys’ and accountants’ fees, closing costs, title insurance premiums, transfer taxes as a result of such action, interestcharges

- Costs incurred by Landlord for trustee’s fees, partnership organizational expenses and accounting fees except accounting fees relating solely to the ownership and operation of the Building (exclusive of the incremental accounting fees to the extent incurred separately in reporting operating results to the Building owners or lenders)

- Costs of a capital nature, including, without limitation, capital improvements, capital repairs, capital equipment and capital tools, all as determined in accordance with generally accepted accounting principles other than those costs of capital improvements which are necessary to comply with any legal requirement or which Landlord reasonably estimates would reduce the costs otherwise included in Operating Expenses, so long as the costs of such capital improvements are included in Operating Expenses only as amortized over the reasonably estimated useful life thereof


Exclusions:


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- Landlord’s general corporate overhead and general and administrative expenses- Income and franchise taxes, special assessments and other business taxes payable

by Landlord except those business taxes which relate solely to the operation of the Building (and Real Estate Taxes if billed separately!)

- All amounts which would otherwise be included in operating expenses which are paid to any affiliate or subsidiaries of Landlord, or any representative, employee or agent of same, to the extent the costs of such services exceed the competitive rates for similar services of comparable quality rendered by persons or entities of similar skill, competence andexperience

- Except for the management fee paid to the property manager of the Building (*see below), all other fees for management of the Building

- Management fees in excess of 4% of gross revenues collected- Costs or expenses of utilities directly metered to tenants of the Building and payable

separately by such tenants- Any increase in an insurance premium to the extent that such increase is caused or

attributable to the use, occupancy or act of another tenant


Exclusions:


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- Any expenses for which Landlord has received actual reimbursement (other than through Operating Expenses)

- Rental for any space in the Building set aside for conference facilities, storage facilities or exercise facilities (*consider management office and other amenities)

- Additional costs incurred to correct violations existing on the Commencement Date of any law, rule, order or regulation affecting the Building beyond those costs incurred in order to maintain the Building in a state of compliance with any such law, rule, order or regulation and any sums paid by Landlord for any fines or penalties as a result of violation of any law, rule, order or regulation

- Any cost or expense related to removal, cleaning, abatement or remediation of hazardous materials in or about the Building or Property in violation of applicable environmental laws


Exclusions:


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Real Estate Tax Exclusions:- Real Estate Taxes shall not include the following taxes and charges:

excise, profits, estates, inheritance, succession, gift, transfer, franchise, capital, other tax assessments on Landlordor on the rent, gross receipts taxes, and interest and penalties (not attributable to Tenant’s late payments)

- Additional considerations:• Property not fully assessed• Increases due to sale of Property


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Sample landlord friendly inclusions:“Operating Expenses” means all costs, fees, charges and expenses incurred or charged by Landlord in connection with the ownership, operation, maintenance and repair and replacement of, and services provided to, the Property, including, but not limited to, (i) the charges at standard retail rates for any services provided by Landlord pursuant to Section 7 of this Lease, (ii) the cost of insurance carried by Landlord pursuant to Section 8 of this Lease together with the cost of any deductible paid by Landlord in connection with an insured loss, (iii) Landlord’s cost to Maintain the Property pursuant to Section 9 of this Lease, (iv) the cost of trash collection, (v) to the extent not otherwise payable by Tenant pursuant to Section 5 of this Lease, all levies, taxes (including real estate taxes, sales taxes and gross receipt taxes), assessments, liens, license and permit fees, together with the reasonable cost of contesting any of the foregoing, which are applicable to the Term and which are imposed by any authority or under any Law, or pursuant to any recorded covenants or agreements, upon or with respect to the Property, or any improvements thereto, or directly upon this Lease or the Rent or upon amounts payable by any subtenants or other occupants of the Premises…


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Allocating Operating Expenses in Commercial Real EstateLeases

…or against Landlord because of Landlord’s estate or interest in theProperty,(vi) the annual amortization (over their estimated economic useful life or payback period, whichever is shorter) of the costs (including reasonable financing charges) of capital improvements or replacements (a) required by any Laws, (b) made for the purpose of reducing Operating Expenses, or (c) made for the purpose of directly enhancing the safety of tenants in the Building, and(v i i ) a management and administrative fee equal to five percent (5%) of the sum of all Minimum Annual Rent from the Property.


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Sample Tenant friendly exclusions:Notwithstanding anything in this Lease to the contrary, there shall be excluded from Shopping Center Expenses the following: (A) costs of alterations, capital improvements (except those capital improvements expressly included in the definition of Shopping Center Expenses set forth above) or additions to the Shopping Center or of any other tenant; (B) any amount paid as ground rental by Landlord; (C) salaries of Landlord’s or its manager’s executive personnel; (D) legal fees, space planners’ fees, real estate brokers leasing commissions and advertising expenses incurred in connection with any leasing in the Shopping Center or the Premises; (E) costs and expenses for which Landlord is reimbursed by insurance from its carrier or any other tenant’s carrier; (F) the cost of repairs, alterations or replacements required as the result of the exercise of any right of eminent domain to the extent Landlord receives net condemnation proceeds as the result of such exercise; (G) the cost or expense of any additional or extraordinary services provided to other tenants in the Shopping Center; (H) court costs and legal fees incurred to enforce the obligations of tenants under leases of portions of the Shopping Center…


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…(I) auditing fees, other than those in connection with the maintenance and operation of the Premises and the Shopping Center or in connection with the preparation of Landlord’s statements for Shopping Center Expenses; (J) any expenses for which Landlord has received actual reimbursement (other than as additional rent); (K) costs or expenses for removal, containment, encapsulation, or disposal of hazardous waste, toxic materials, asbestos or any other form of contamination not caused by Tenant and repair or cleaning of areas affected by same; (L) costs incurred in connection with a transfer or disposition of all or any part of the Shopping Center or any interest therein or in Landlord or any entity comprising Landlord; (M) any expense arising by reason of the negligence or other tortious conduct of Landlord or Landlord’s employees, agents or contractors; (N) payments for rented equipment, the cost of which would constitute a capital expenditure if the equipment were purchased; (O) any fines or penalties incurred as a result of violation by Landlord of any law, order, rule or regulation of any governmental authority, unless caused by acts or omissions of Tenant; (P) marketing fund, merchants association or similar charge; (Q) capital expenses in excess of the amount determined by amortizing such expenses over their useful life; and (R) management fees in excess of three percent (3%) of the gross revenues from the Shopping Center.


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Applies when the building is not fully occupied or leased (sometimes95%).

Generally applies to “variable” operating expenses, i.e., operating expenses that vary based on the occupancy of a Building- Utilities- Janitorial services- Certain HVAC costs

Two percentages to consider:- Percentage of the Building occupied before the provision applies

• May only kick in when occupancy falls below a certain level (80%)- Percentage of the Building deemed to be occupied for calculation

purposes (commonly 95% or 100%)

Gross Up Provisions

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Types of Caps- Dollar Amount- Percentage Increase on all Operating Expenses- Percentage Increase on certain Operating Expenses

Considerations when drafting a cap on increase in Operating Expenses from the previous year:- What expenses does the Cap apply to?- If less than all, definitions are important- Controllable expenses v. Noncontrollable expenses- Percentage increase: 3-5% is typical range- Cumulative v. non-cumulative

Expense Cap Provisions

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General process and timeline Time periods are very important Who can perform the audit?

- Certified Public Accountant- Tenant’s employees

Where does the audit take place? What is the scope of the audit? How is the auditor paid?

- Often contingency basis fee is not permitted- Who pays the costs of the audit?

“True up” sentence or two

Tenant Audit Rights

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Who pays costs of the audit?- Auditor fees- Landlord admin costs

How often can Tenant audit? Dispute resolution mechanism Confidentiality Survival Do Tenants actually use this right?

Tenant Audit Rights

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Sample Audit Provision 1:Provided Tenant is not then in default under this Lease, Tenant shall have the right to audit Landlord’s books and records regarding Operating Expenses, provided that such audit is conducted pursuant to the following terms and conditions: (i) Tenant shall conduct no more than one (1) audit per two (2) calendar years; (ii) Tenant shall conduct such audit during normal business hours upon at least thirty (30) days prior written notice to Landlord, at Landlord’s business address; (iii) such audit must commence within four (4) months after Tenant’s receipt of the given statement which Tenant desires to audit; (iv) such audit shall only pertain to the most recent statement of Operating Expenses provided to Tenant and records relating to Operating Expenses for the most recent calendar year; and (v) such audit shall be conducted by a certified public accountant (which may be an employee of Tenant or an independent accountant retained by Tenant specifically to conduct such audit), whose fee is not charged on a contingency basis. Within sixty (60) days after the completion of such audit, Tenant shall supply Landlord with a copy of the audit report. If such audit report conclusively establishes an underpayment by Tenant to Landlord, or an overpayment by Tenant to Landlord, as agreed upon by the parties, the parties shall make payments accordingly. Tenant shall pay the fees and expenses related to such audit, unless the audit determines that Landlord overstated Operating Expenses by more than five percent (5%), in which case Landlord, within thirty (30) days after demand, which must be accompanied by reasonable backup documentation, from Tenant, shall pay such fees andexpenses.


Tenant Audit Rights

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Sample audit provision 2:Tenant, at its sole cost and expense, shall have the right, within ninety (90) days after receiving a Cost Summary to review Landlord’s books and records relating to the Shopping Center Expenses for the prior year.

If within such ninety (90) day period Tenant does not give Landlord written notice stating in reasonable detail any objection to the Shopping Center Expenses, Tenant shall be deemed to have approved such statement in all respects and Tenant shall have no further right to audit or otherwise challenge the statement. Such review shall be conducted only after Tenant gives Landlord thirty (30) days’ prior written notice. Tenant’s audit or inspection shall be conducted where Landlord maintains its books and records in the continental United States and shall be conducted only during business hours reasonably designated by Landlord. Tenant shall deliver to Landlord a copy of the results of such review, if any, within thirty (30) days thereafter. If Landlord and Tenant are not able to agree on the amount of any adjustments to Shopping Center Expenses within thirty (30) days following the delivery of Tenant’s results, Tenant, at its sole cost and expense, may hire an independent and reputable certified public accountant in the area in which the Premises are located, to audit the Shopping Center Expenses inquestion…

Tenant Audit Rights

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…The accounting firm conducting such audit shall submit its audit report simultaneously to Landlord and Tenant, and Landlord shall have the option within fifteen (15) days after receipt of the report (the “Comment Deadline”) to notify the auditor of any reasonable comments by Landlord which shall be incorporated into the final audit report prior to the report being finalized. The auditor shall prepare and submit to Landlord and Tenant the final report to Landlord and Tenant within fifteen (15) days after the Comment Deadline.The results of such audit shall be binding on the parties. All information obtained through the Tenant’s audit with respect to financial matters (including, without limitation, costs, expenses, income) and any other matters pertaining to Landlord and/or the Shopping Center as well as any compromise, settlement, or adjustment reached between Landlord and Tenant relative to the results of the audit shall be held in strict confidence by Tenant and its officers, agents, lenders, employees, accountants, attorneys and business advisors, except that such parties shall be permitted to disclose such results as required by law or with respect to a dispute between Landlord and Tenant; and Tenant shall cause its auditor and any of its officers, agents, lenders and employees to be similarly bound.

Tenant Audit Rights

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…If the audit discloses that the total amount invoiced to Tenant after year-end reconciliation for such year exceeds the actual Shopping Center Expenses, Landlord, at Tenant’s option, shall either credit the amount of overpayment towards Tenant’s next due payment(s) of rent or any other amounts due under this Lease, or refund the same to Tenant within thirty (30) days after written demand therefor. In addition, if such audit discloses that Tenant has been overcharged by five percent (5%) or more of Tenant’s share of Shopping Center Expenses, then Landlord shall reimburse Tenant for the cost of the audit within thirty (30) days after written demand therefor. If such audit discloses that the total amount invoiced to Tenant after year-end reconciliation for such year is less than Tenant’s share of Common Area Costs, Tenant shall promptly pay the difference to Landlord. Landlord’s and Tenant’s obligations under this paragraph shall survive the expiration or sooner termination of this Lease.

Tenant Audit Rights

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Allocating Operating Expenses in Commercial Real EstateLeases

Considerations for our “new normal” Building Closures:

- Decreases operating expenses due to building closures- Re-estimate Tenant’s operating expense payment now or

wait to true-up at the end of the year? Building Reopenings:

- Health measures: taking temperatures, masks- Distancing in common areas

Cleaning Costs:- Enhanced cleaning specifications and cost

COVID-19 Considerations

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Bonus Slides


Costs of services/benefits offered only to certain tenants or in excess of building standard

Compensation paid to clerks, attendants or other persons incommercial concessions operated by Landlord including theparking garage of the Building

Advertising and promotional costs associated with leasing of the Building

Costs of signs in or on the Building (other than the Building lobby directory)

Costs of purchasing or leasing major sculptures, paintings or other major works or objects of art (as opposed to decorations)o Sometimes written as “no fine art”

Bonus Exclusions

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Hannah Dowd McPhelinProfessional Development Partner, Real Estate Practice [email protected]

Concentrates her practice in real estate matters and other business transactions, including the acquisition, sale and financing of commercial real estate properties and leasing of office, retail, warehouse and industrial space, representing both landlords and tenants

LEED® (Leadership in Energy and Environmental Design) Accredited Professional

Member of The Counselors of Real Estate (CRE) Member of CREW (Commercial Real Estate Women)

Philadelphia and served as past chair of Communications Committee.

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mailto:[email protected]

Julia TomecPartner, Real Estate Practice [email protected]

Concentrates her practice in the acquisition, sale, development, leasing and financing of commercial real estate properties, representing real estate investment managers, entrepreneurial developers and nationalretailers

Represents private real estate investment management funds, national retailers, and manufacturers

Represented numerous companies in diverse industries such as retail, office and industrial locations, corporate expansions, consolidations, relocations and corporate headquarters leases.

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mailto:[email protected]

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Thank you!

These materials and commentary are intended for educational purposes only. No portion may be construed as rendering legal advice for specific cases, or as creating an attorney-client relationship between the audience and the author. The opinions expressed herein are solely those of the authors.

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