Commercial Leases: Operating Expenses

Another part of a commercial lease that needs to be specifically examined is operating expenses. Operating expenses may be a part of additional rent, or it could be contained in a separate provision. Regardless, the section needs to be scrutinized by the tenant.

Generally, a landlord will begin by defining operating expenses as broadly as possible. This could include a lot of things for which the tenant will not want to be responsible. Usually, a landlord is not expecting that a tenant will simply agree to this broad liability by the tenant, but they will certainly be happy if the tenant agrees to it.

Tenants will generally seek to exclude from operating expenses things like capital improvements, debt financing, construction costs for improvements of other tenant space, costs covered by landlord insurance, and costs covered by warranties held by the landlord. In addition, tenants will want to seek to exclude costs of disputes between the landlord and other tenants, costs related to concessions operated by the landlord, and the cost of beautification of the common areas of the property. In short, tenants want to limit their exposure to the things they control like their own use and risks, or things related to their space.

Operating costs are generally variable and the tenant needs to pay special attention to how the costs are calculated, whether they can be challenged, how to verify the costs, and to consider what incentives or checks exist to make sure the costs are appropriate and are incurred responsibly.

Operating costs can be addressed in different ways. One is to make the tenant responsible for a pro-rata share of the costs based on the proportion of the space leased. Another is to apply a flat rate, possibly based on historical costs. A tenant can also potentially negotiate a cap or ceiling for the costs. In some situations, it may be appropriate to combine these methods in various ways. In addition, landlords may seek terms that ensure they can collect all of the costs actually incurred even if there is a portion of the property that is vacant. Naturally, a tenant wants to protect its own interests and make sure the landlord has the right incentives regarding vacant space.

One needs to remember that a landlord’s perspective is going to be different from the tenant’s. A landlord is looking at the totality of the property and how all of the tenants, and the leases, will work together to put the landlord in a profitable position. This can include taking steps to try to lure the best tenants and/or complimentary tenants. The landlord is looking for a web of responsibilities and obligations which will give the landlord the best opportunity to cover its costs and make a profit. Sophisticated landlords will engage in a strategy that takes into account these different factors to create value for the tenants, and itself. Accordingly, sometimes landlords will provide benefits to larger “anchor” tenants, or more desirable tenants (based on the landlord’s own criteria), to incentivize those tenants to lease space. This can provide other tenants with significant value, but it also likely means the landlord will try to recoup these costs elsewhere, often with other tenants who have less bargaining power. Tenants need to be cognoscente of this reality, and be prepared to address it intelligently.

In summary, the first issue for a tenant is to limit operating costs to an appropriate scope. Second, the tenant needs to figure out how the operating costs are being calculated and charged. Third, the tenant should consider how its obligations mesh with the obligations of the other tenants.