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When entering into a commercial lease, one of the more important terms negotiated between the parties pertains to the manner in which the landlord will recoup its operating expenses. After all, commercial landlords are in business to make money. Without addressing its operating expenses, a landlord’s return on investment would be whittled away to nothing. While the more sophisticated players in the industry are thoroughly familiar with the various techniques available, many tenants – and some landlords – are not so well informed. What follows is a brief primer on some of the various methods utilized to protect the landlord’s return on its investment.
The most common form of commercial lease is the triple net lease. In a triple net lease, the tenant is responsible for its proportionate share (i.e. tenant’s square footage divided by the total building square footage) of property taxes, insurance, common area maintenance and utilities. These charges, commonly knows as “CAM, tax, and insurance” expenses, are in addition to the tenant’s base rent and any other expenses associated with the tenant’s occupancy (i.e. utilities, garbage collection, cleaning services and the like). Many leases will estimate these charges for a particular year, and then reconcile the amounts with the actual charges incurred for the year. If the tenant paid too much in a particular year, the tenant will get a credit toward rent. If the tenant paid too little, it will receive an invoice from the landlord for the difference – usually payable as additional rent.
Another common form of commercial lease is what is known as a “base year lease.” A base year lease is often employed in office leases where the landlord is cognizant of his return on investment in the building taking into account current income and expenses. The “base year” is typically the calendar year in which a tenancy commences. Unlike the triple net lease, the tenant in a base year lease reimburses the landlord for its share of the landlord’s operating expenses only to the extent they exceed the amount of those expenses for the base year. While the concept of a base year is relatively simple to understand, it is critical for any tenant entering into a base year lease to gain an understanding of the history of the landlord’s operating expenses so that it may plan its budget accordingly. Also, a tenant should consider negotiating that the base year be projected a period of time in advance in order to protect itself from having to experience a rent increase shortly after commencing its term in those instances where the term commences relatively shortly before the base year ends.
Another type of lease used most often in multi-tenant and single tenant office buildings, as well as industrial and retail properties is the “gross lease.” In the gross lease, the landlord pays for taxes, insurance, and maintenance. The landlord collects a fixed base rent and pays the operating expenses out of them. Many of these types of leases will, however, contain an “escalation clause”, which typically requires the tenant to pay increases in operating expenses and tax increases over a base year figure or expense stop.
It is important that a tenant shopping for space have a basic understanding of how operating expenses are to be handled in their lease so as to avoid any unpleasant surprises down the road with regard to rent increases.