However, because market indices such as the CPI are large scale in nature, they rarely ref lect the operating expense changes felt by the landlord at a particular building. As a result, while tying rent increases to the CPI is, from the landlord’s perspective, an improvement over the traditional gross lease, landlords prefer to make any escalation under the lease relate more directly to operating expenses as opposed to the base rental rate.
One way that landlords can accomplish this is to insert an expense stop into the lease. An expense stop puts a dollar limit on the total operating expense that the landlord is obligated to pay. Expense stops are usually calculated on a dollar per square foot basis, which serves as the benchmark against which future increases in operating expenses will be measured. If, for example, the landlord agrees to pay $1.00 per square foot in operating expenses and such operating expenses increase to $1.10 per square foot in the second year of the lease, the tenant would be responsible for its pro rata portion of the additional 10 cents in operating expenses. The expense stop need not ref lect the actual amount of operating expenses that the landlord is paying at the time the lease is negotiated. Rather, the expense stop is a negotiable amount that depends in large part on the strength of the commercial lease market. Thus, the higher expense stop that the tenant can negotiate,
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the better off the tenant will be if there are future increases in operating expenses.
Another way landlords try to limit their exposure to future increases in operating expenses is to insert a base year provision into the lease. Similar to the expense stop, a base year clause provides that the landlord will be responsible for paying the operating expenses incurred during whatever “base”
year that the parties agree on, and the tenant will be responsible for paying for any increases in operating expenses that occur after the base year. Again, because operating expenses are almost always on the rise, it is in the tenant’s best interest to try to negotiate a lease with a base year provision that is either the year the lease is executed or the following year, whereas the landlord will try to incorporate a base year provision that relates to the year prior to the lease commencement.
NET LEASES.
As opposed to the modified gross lease that establishes a
f loor above which the tenant is responsible for paying operating expenses, under a net lease, the tenant pays its pro rata portion of the operating expenses. Net leases come in one of three different varieties: net leases, net-net leases, and triple-net leases. According to the Urban Land Institute, the difference between these versions of net leases can be explained as follows: In the net lease, the tenant is usually required to pay its pro-rata share of all utilities, ad valorem taxes, and any other special assessments associated directly with the leased premises. In the net-net lease, the tenant pays its pro-rata share all of the above costs of a net lease plus its pro-rata share of the cost of the ordinary repairs and maintenance of the common areas and building systems. The triple net lease usually requires that the tenant pay its pro-rata share of all of the above costs of the net-net lease plus the cost of certain capital improvements.5
Given the foregoing description of the various types of net leases, it should come as no surprise that landlords favor the triple-net lease.
GROSS UP.
Grossing up is a mechanism that is often employed in an effort to account for increases in operating expenses when, in the base year, the building occupancy rate is less than 100 percent. If, for example, in a building that is 50 percent occupied, a tenant negotiates a lease with an expense stop or base year provision of $10 per square foot, then without a gross-up provision, the tenant will be liable for not only the annual increases in operating expenses that are contemplated when negotiating the lease but also any increases in operating expenses that are attributable to increased occupancy.
Thus, in the foregoing hypothetical, if the building goes from 50 percent occupancy in year one to 100 percent occupancy in year two, the operating expenses for which the tenant is liable will increase dramatically, from the negotiated amount of $10 per square foot to, for example, $13 per foot.
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Although occupancy rates have effectively doubled in this example, because a significant portion of operating expenses are fixed regardless of occupancy rates, operating expenses will increase by only a fraction of the increase in occupancy. Examples of fixed expenses include security, garage expenses, landscaping, and insurance, whereas variable expenses include items such as repairs and maintenance. If, in calculating the expense stop or base year, the landlord had grossed up expenses as if the building were fully occupied, the tenant might have been able to negotiate a higher expense stop or base year.
Thus, in considering the rental rate and expenses that are within the professional services firm’s budget, the firm should confirm that any expense stop or base year provision is based on a grossed-up operating expense figure. Further, regardless of the manner in which the gross-up calculation is performed, the tenant should insist that the landlord be precluded from recovering more than 100 percent of its actual operating expenses in any given year.
Property Inspection/Walk-Through
Once a list of potential office buildings has been narrowed down, the next step is to arrange meetings with the appropriate leasing agents and landlords to conduct building inspections. Many of the things that the firm considers when conducting the physical property inspections are similar to the topics that the firm should have reviewed on paper. Nevertheless, to confirm or dispel any conclusions that the firm reached based on preliminary due diligence, it is important that the firm take into account each of the following considerations when touring potential office space.
FUNDAMENTAL ASPECTS OF THE BUILDING.
Are the building and pro-
posed office space consistent with the image the firm is trying to project?
While the design, finish-out, and furnishings can have a dramatic impact on the overall ambience and feel of the office, there are certain immutable things that the potential tenant cannot modify or which can be changed only at great cost. The façade of the building, natural lighting, landscaping, and access to parking (both tenant and visitor) are all factors that should be considered when conducting the physical inspection.
COMMON AREAS.
Bear in mind that the first thing a client or potential
client is going to see when entering an office building is the foyer. Pay attention to the quality of the finish-out in the foyer and other common areas in the building. Additionally, note whether there is a tenant directory in the foyer, as well as an information/security desk.
PROPERTY MANAGEMENT/MAINTENANCE.
During the property inspec-
tion, note the general appearance of the interior of the building and the level of upkeep/maintenance. Although this should not be a problem in most Class A
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buildings, different property management companies have different styles and provide different levels of service. If the other tenants in the building have had problems with the building manager or it appears that management is not maintaining the building sufficiently, this alone might be a reason to rule out a particular building. On the other hand, if there have been problems with the building management, but the owner is committed to rectify-ing the situation by, for example, switching management companies, it might be a nonissue.
CURRENT OFFICE DESIGN.
Although a cursory review of the office lay-
out can be undertaken on paper, pay attention to the location of the interior walls, size of the offices, and whether significant improvements will need to be made before taking possession.
ELEVATORS.
When touring an office building, note where the available of-
fice space is located in relation to the elevator bank. If the firm is not going to lease an entire f loor of an office building, it may be important for the firm to be located close to the elevator bank so that it is one of the first offices that clients and potential clients see. Although the f loor plan should depict where the office space is located vis-à-vis the elevator bank, the tour should give a sense of the exact location and whether the exposure is optimal.
TAKE NOTES.
Whoever participates in the property tour on behalf of the
firm should bring along a notepad or a form to complete during the property inspection because it is often difficult to remember details about each particular building as the tour proceeds. Notes will prove valuable when discussing the options with members of the firm who may not have participated in the property inspection.
MAKING A DECISION.
Once the property inspection has been completed,