Understand your lease, avoid unexpected expenses
August 21, 2014
It is not uncommon for our office to receive phone calls from commercial tenants whose leases are nearing expiration and who feel they did not get what they bargained for when they originally signed their lease. Often, these tenants incurred significant unexpected charges or expenses during their lease term, which soured their relationship with their landlord and motivated them to find space elsewhere rather than extend their lease.
I feel the majority of these situations are not the result of intentional wrongdoing or purposeful deceit on the part of the landlord, but rather they emerge due to a lack of knowledge and understanding, primarily on the part of the tenant. This makes sense when you consider that landlords typically generate the lease documents and are therefore very familiar with their content. In addition, the majority of landlords have signed numerous leases with many tenants over many years. In contrast, a business tenant may only be a signatory on a commercial lease a couple of times during their entire career, and gaining an in-depth understanding of an unfamiliar and complicated multi-page legal document packed with small print can be a daunting task, not to mention an unwelcome interruption to running a business.
I would say that many landlord/tenant financial misunderstandings relate to "operating expense" clauses in the lease. Property investors (aka landlords) purchase commercial property in anticipation of a projected return, and they, quite logically, seek to reduce risk and maintain that return over the life of the investment. Therefore, it is reasonable that landlords typically look to pass property operating expenses on to their tenants by way of a "net" lease. The problems arise, however, when, due to the complexity of the property operating cost language: 1) tenants do not understand what they are signing and the affect that operating expense clauses will have on their total rental expense; or 2) the tenant is suddenly hit with a crippling increase in operating expenses due to broad and open-ended lease provisions that were not negotiated or limited to any degree. If tenants take the time to understand the true financial implications of their lease up front, or secure representation from experts such as real estate attorneys or commercial real estate brokers, then they will have the opportunity to negotiate lease terms that are realistic and acceptable to their business needs, or alternatively, choose another building that falls within their budget.
Property operating expenses generally fall into three primary categories – property taxes, insurance and maintenance. The term "triple net" (or, "NNN") relates to these three expense groupings. A triple net lease therefore would be a lease where your base rent payment is "net" of taxes, insurance and maintenance charges, but where these expenses are billed to you separately in addition to your base rent. A "net" lease rate will, therefore, typically be less than a "gross" lease rate which already has operating expenses built in.
To avoid unpleasant and financially burdensome surprises when considering signing a net lease, I recommend the following:
− Request from the landlord a detailed breakdown of the property operating expenses over the past few years. From this, you should be able to determine which expenses are actually being passed through and whether there have been wide swings in the amount of total expenses each year.
− Examine closely the lease language defining "operating expenses." Operating expenses should NOT include things like: i) capital expenditures (a tenant should not have to pay for the landlord's brand new roof); ii) personal property (the lawn mower the landlord bought primarily for his home); iii) income and capital gains taxes; iv) expenses for which landlord is reimbursed by any third party, other tenant, or insurance proceeds; v) loan fees, mortgage payments; vi) un-earmarked reserves; vii) various other costs that sometimes appear in leases but that do not relate to typical building operating expenses.
− As property taxes are often the most expensive component of operating expenses, a tenant should pay special attention to any property tax related lease clause(s). Can items such as municipal improvement bonds be included with property tax pass-throughs? If so, be sure to know what these items total. If the property sells at a much higher price than currently assessed, are you fully obligated to pay the entire tax increase when the property is reassessed?
− Request that triple net charges (sometimes called "CAMs" or common area maintenance fees) be estimated annually and billed in equal monthly installments that can only change upon prior written notice by landlord.
− Attempt to negotiate a reasonable cap or limit on the amount that operating expenses may increase each year. If you are paying $.15 per square foot in triple net charges and then they suddenly increase by 100 percent to $.30/sf, this could gravely affect your operational cashflow.
Lock Richards specializes in acquisitions, dispositions and leasing of commercial and investment properties. He has more than 25 years of experience in the field, including over 15 years in the Grass Valley/Nevada City area. His "Commercial Property Review" newsletter, full of current Nevada County market trends and specific property details related to industrial, office and retail properties, is available at http://www.svnhighland.com or by calling Lock at 530-470-1740.
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