Chris Carmen  /   March 13, 2020

Every commercial building has operating expenses. Building operating expenses are handled in various ways depending up on the type of property, i.e. office, industrial, retail, etc. and the structure of the lease, whether it be Triple Net, Gross, or Modified Gross, but regardless of how the expenses are billed, one thing is for certain: The tenant ALWAYS pays the building operating expenses. Such operating expenses may include utilities, property insurance, real estate taxes, housekeeping, maintenance and repairs, and any costs related to operating a building. In general, only accrued expenses can be considered operating expenses as defined by GAAP.  However, some capital expenses can also be attributed to operating expenses.

In most cases, tenants pay their share of estimated operating expenses each month throughout the year and after the end of each calendar year each tenant is presented with the annual operating expense reconciliation. This document is meant to compare the estimated expenses for the year versus what the tenant paid during the course of year.

How Operating Expense Reconciliation Works

Following the end of each calendar year, landlords must send out the operating expense reconciliation reports. The operating expenses of the building are calculated and broken down by each expense area, such as utilities, housekeeping, real estate taxes, property insurance, landscaping and snow removal, repairs and maintenance, etc. and is then put into terms of cost/square foot. Each reconciliation report should be itemized so tenants can see the specifics of how the building operating expenses were calculated.

If the landlord passes through unusually high costs to the tenant or the tenant overpays estimated expenses during the year, compensation will have to be settled between the two sides based on the operating expense reconciliation. When tenants overpay, they are refunded or otherwise compensated through a rent credit. When they underpay, they must make up the difference with an additional payment. Although it is highly unusual, if the estimate of expenses was accurate to the cent, neither party owes the other party and nothing changes.

Typically, reconciliation is done on a pro rata basis. No tenant is responsible for 100% of the operating expenses unless they are occupying 100% of the rentable space. Much of how the reconciliation is handled comes down to how the lease was written.

Lease Types Affect Operating Expenses

Tenant responsibilities are defined in the lease itself. As mentioned above, certain types of commercial property leases take on more or less responsibility for expenses.

For comparison, look at a triple net lease versus a gross lease. Gross leases are common in office buildings. In these leases, the landlord takes on all operational costs in the building are included in the tenant’s base rental payment, with the tenant paying a higher rate per square foot. In a triple net lease, the tenant is still responsible for 100% of the building operating costs, however, those costs are billed outside the tenant’s base rental payment.

Gross leases and modified gross leases include the base operating expenses in the base rental payment but are limited to the expense amount of the year when the lease commences. However, if the operating expenses increase during the term of the lease, the tenant is responsible for paying the difference between the base expense amount and the increased amount of operating expenses. The first year of the lease is generally considered the base year, establishing the amount of operating expenses within the base rent.

Sometimes tenants are able to negotiate a “Cap” on expenses increases, those expenses the tenant must pay in addition to the base rent. For example, if the lease states that the expenses covered by the landlord can grow by a maximum off 4% every year and the operating expense increase exceeds 4%, the tenant is only responsible to pay up to the 4% increase over the prior year’s expenses and the landlord would not be able to recover the building operating expenses in excess of the 4% cap..

Tenants need to pay close attention to the type of commercial lease they’re signing and how it the building operating expenses will affect their overall cost of occupancy.. Further, In case of foul play from the other side, it’s also wise to know what the next steps are to correct the situation.

Taking Action

What can be done in case of an unfavorable operating expense reconciliation? Sometimes, these reports are accurate and must be respected once confirmed by the tenant for accuracy. However, in some cases, the landlord or property manager may misclassify the expenses as a building operating expense when it is a capital expense, or the landlord or manager is simply being dishonest and inflating the costs in order to benefit themselves.

So what remedies does a tenant have if they suspect there is an issue with the operating expenses being billed by the landlord of property manager? Here are a few ways to respond to reconciliations:

  • Tenant Audits

    If the landlord presents a tenant with an expense report that shows expense growth of higher than 3-4%, tenants should always seek out an audit. There’s little reason that expenses should grow by more than this year over year, unless it’s a new expense that’s discussed beforehand with the building tenants. Historically, building operating expenses generally follow the Consumer Price Index (CPI), which gives the tenant some rough idea of how to index their building’s expense growth. If the CPI has increase for a given year at 2.73% and the landlord is showing an operating expense increase of 5% over the prior year’s building operating expenses, this can be an indication that something is wrong and the expenses should be looked into more closely.

    If the tenant is savy enough, it might take audit the landlord’s expenses per the operating expense reconciliation. However, if the amount of money is significant enough, it may warrant engaging an accountant to conduct the expense audit. But keep in mind, if the difference between the expense increase the landlord is billing and CPI reflects a dollar amount that is not worth the time and expense of engaging an accountant or even digging through the expenses yourself, it might be not be worth spending any more time on it than simply calling the landlord and asking “hey, why have the building operating expenses increased so much since last year?”

  • Contract Negotiations

    Before any contract is finalized, make sure you always read and understand the fine print dealing with expenses. The definition of building operating expenses, or simply put: who pays what and how much are always present in a commercial lease, such as an office or warehouselease. It’s better to know beforehand what you will be responsible for over the years rather than being shocked by a large increase in expenditure after a few years in a building.

  • Real Estate Lawyers

    If the landlord is being uncooperative, dishonest, or you believe is not following what has been defined in the lease, it may be a good idea to involve an experienced real estate lawyer. This lawyer might be able to push for the necessary actions to take place, helping each side to get a fair outcome.

If the landlord is being uncooperative, dishonest, or you believe is not following what has been defined in the lease, it may be a good idea to involve an experienced real estate lawyer. This lawyer might be able to push for the necessary actions to take place, helping each side to get a fair outcome.

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