In the Spotlight: Negotiation of Operating Expenses in an Office Lease

With so much of today's retail space being leased in mixed-use buildings, especially office buildings, developers and retailers should familiarize themselves with leasing concepts inherent in office leases. While the inner workings of CAM charges in a shopping center are familiar territory for the developer and the retailer, the negotiation of operating expenses in an office lease poses a different sort of challenge. It is important to discuss this topic because the allocation of which party pays the costs of an office building's operating expenses is one of the most negotiated provisions in an office lease.

Naturally, a landlord will attempt to include as many items as possible in its list of building operating expenses of which tenant must pay a proportionate share, and a tenant will attempt to exclude as many of those items as it can. Negotiation of what is included and excluded in operating expenses can have a drastic effect on a tenant's (and landlord's) bottom line. What first seems like an acceptable figure for base rent may no longer look like a bargain after a landlord's laundry list of operating expenses is added to the mix. The intent of this discussion is to provide a brief overview of commonly negotiated operating expenses. This article presents both the landlord and tenant perspective for each operating expense issue discussed.

List of Exclusions

Any sophisticated tenant's broker will have a list of building expenses that are typically excluded from the list of operating expenses included in a lease form provided by a landlord. Such items will represent those building expenses that are traditionally paid for solely by the landlord in the particular market in which the building is located. A tenant should not expect that a landlord will automatically agree to exclude every item that is on such a list, but using a broker's list of suggested exclusions is a good starting point for negotiating operating expenses. Of course, those same brokers representing the tenant will have a separate list of operating expense inclusions when they are representing landlords.

Capital Expenditures

A capital expenditure is commonly defined as any expenditure that extends the life of an asset. The issue of which party bears the costs of capital expenditures is often a touchy subject since capital expenditures can be very expensive. It is a common tenant position that the cost of a capital expenditure is a cost that should be born solely by the landlord, since paying for capital expenditures is part and parcel of ownership of a building. Knowing this, a landlord will still want to include the entire range of possible capital expenditures, or alternatively, attempt to characterize certain capital expenditures as operating expenses so that it can at least pass on some of the costs of special big-ticket items purchased for the betterment of the entire office building to the tenant.

Capital expenditures that are replacements of core building systems or repairs of structural, design, mechanical, or engineering defects are usually paid for by the landlord. However, landlords often try at least to carve out certain capital expenditures to be paid for by tenants on the theory that certain capital expenditures greatly benefit the tenant and are not necessarily a cost of owning the asset. For example, landlords may demand the following to be included as operating expenses: 1) capital expenditures that are made to improve life, safety, and security features of the office building, 2) capital expenditures that are made to comply with recently enacted laws or laws that have passed but will not take effect until a future date, and 3) capital expenditures that will improve building systems and result in a decrease of the cost of operating expenses. However, if a tenant agrees to this, it should expect that the actual cost of its proportionate share of a capital expenditure will not be more than the amount the landlord expects to save as a result of the particular capital expenditure. Since bright-line standards for determining what falls under the category of capital expenditures are not easy to identify, many leases include provisions that specifically list what is and what is not a capital expenditure. The key question is whether the particular expenditure is more a cost of ownership of the asset or a cost of operating and maintaining the asset.

Replacements

Should a landlord or tenant pay for the replacement of rugs in the elevator? The replacement of a water fountain in the lobby? A landlord will argue that it should not bear the costs of replacing items that are used by tenants on a daily basis, especially since the need for the replacement was most likely necessitated by tenant usage. On the other hand, a tenant will argue that the cost of making everyday building replacements is simply a cost of ownership for the landlord (an argument that a tenant will make many times during the negotiation of operating expenses). Nevertheless, if pushed by a landlord, a tenant should try specifically to identify categories of replacements it is willing to pay for, such as: 1) replacements that cost less than a negotiated price cap; 2) replacements of common area beautification items (i.e., plants, lighting, etc.), which benefit a tenant and its guests on a daily basis, or 3) replacement of common building items which serve fundamentally practical purposes (e.g., faucets in bathrooms, water fountains, etc.).

There is a debate as to whether tenants should pay for replacements that were not purchased for the purpose of improving the replaced building function (i.e., lowering costs and providing enhanced service) but replaced because of a desire by the landlord merely to update an old building function with a new one. However, it is rather difficult to prove that a replacement item does not provide some sort of improvement over the old item. Therefore, many landlords will be reluctant to exclude replacements from operating expenses, especially in large office buildings where replacements may very well be necessary every day.

Equipment

Landlords and tenants often argue about whether equipment purchased for an office building constitutes a capital expenditure, the cost of which is borne by the landlord, or a basic operating expense, the cost of which is borne by the tenant. The parties should ask the following question: Is the purchased equipment more in the nature of an expenditure designed to extend the life of an asset or is it more in the nature of a general operating expense likely to benefit tenants immediately? For example, equipment such as a snow blower does not necessarily extend the life of the office building, but is useful in clearing pathways and entrances for tenants, which seems to fall within the category of operating expenses. On the other hand, equipment that clearly extends the life of an asset, such as a wind-stabilizing device, will more likely be characterized as a capital expenditure for which the tenant is not responsible (but query whether this falls under the life safety capital expenditure carve-out discussed above). In addition, tenants will try to exclude rental equipment that, if bought by landlord, would constitute a capital expenditure. Since it is difficult to delineate bright-line standards to determine what types of equipment should or should not be excluded from capital expenditures, parties to a lease should consider listing specific equipment to be included or excluded from operating expenses (much like how leases specifically identify capital expenditure inclusions and exclusions).

Costs Attributed to a Specific Tenant

A tenant should not have to pay for increases in the insurance costs or real estate taxes that are directly attributable to the activities of another tenant in the office building. For example, if a tenant plans to handle toxic chemicals in its premises (assuming its lease allows such a hazardous activity), the insurance for such tenant will be significantly higher than that for a tenant in the same building with comparable space that is only used for general office space. Why should the tenant using its space for general office use have to bear the costs of another tenant's dangerous activities? For this very reason, a tenant should specifically request that increases in insurance and real estate taxes directly attributable to the unique activities of another tenant should not be included in the list of operating expenses in its lease.

Artwork

Fine artwork and sculptures in the lobbies, common areas, or exteriors of office buildings can increase the social value of a building and, perhaps to a lesser degree, its economic value. At the very least, artwork can transform the cold and institutional office building environment into an engaging, lively, and pleasant one. But is it fair for tenants to share the cost of purchasing a million dollar Picasso painting? Most landlords will not expect tenants to pay for a collection of paintings that should be in the Louvre, but tenants often will bear the costs of cleaning and securing artwork purchased by the landlord. However, tenants should be careful to agree only to pay for commercially reasonable costs of securing artwork to avoid having to pay for state-of-the-art security systems only seen in the movies.

Charitable Contributions

To remain in the good graces of the community in which their buildings are located, landlords often make contributions to local nonprofits and politicians. While tenants may very well make similar contributions, tenants will most likely have an issue with paying for the philanthropic and political preferences of their landlords, especially if such preferences do not align closely with those of the tenants. As a general rule, tenants should not pay for political contributions, but should expect to pay their share of contributions to local charities or nonprofits that are committed to improving or contributing to the neighborhood or business district in which the office building is located. Where political contributions are a much more personal and individual expenditure, a donation to an entity that furthers the community where the building is located benefits not only the landlord, but also the tenant and its employees, guests, etc. However, the landlord will most likely get all of the credit for the donation. A tenant may consider requesting that the landlord provide any recipient of a donation with a list of all tenants that contributed to the donation.

Management Costs

Landlords, especially those that own more than one property, hire and rely upon professional management companies to run the everyday operations of the their buildings. Sometimes the management company is a related landlord entity, and sometimes a landlord's property manager is a third-party specialist. Since management costs and fees can be very expensive, there is plenty of negotiation over which party pays which management expenses. Tenants often pay for the costs of management expenses if the building management office is housed in the building itself. Alternatively, tenants usually do not pay the costs of overhead from management offices located outside of the building in which they occupy space.

In addition, a tenant will most likely not be responsible for the salary of an employee at a grade level higher than property manager. Landlords may try to pass on the cost of the salaries of employees who oversee the property managers and operations of various buildings owned by the landlord. This category of employee presents a tricky issue. On one hand, regional property managers provide a useful function for each building under their purview. However, tenants may find getting charged for both a property manager and a regional manager as a sort of double taxation by the landlord.

Specialty Items

What if a landlord of a large office building decides to build a day care center on the ground floor that caters both to tenants of the building and third-party customers? Or an observation deck for tourists? If the specialty service caters to third parties other than individual tenants of the landlord's building, tenants should not expect to pay for the costs of installing, operating, or maintaining such services since the landlord is most likely receiving income from those services, and the tenants are not the sole beneficiaries of the services. If, on the other hand, the landlord installs a facility solely for tenant use (e.g., exercise room without usage fees), there may be an expectation that the cost be included in the tenant's operating expenses.

Market Considerations

During the negotiation of a lease, the parties should consider how the local market treats a particular building expense ' what are other landlords including in their list of operating expenses and what are other tenants willing to pay for? Of course, regardless of what the market is dictating, landlords will want to include all building expenses that comparable landlords include in similar buildings (or what the landlord includes in its other buildings) in the calculation of tenant operating expenses, and tenants will only want to pay for what other tenants are paying. Landlords may point out other leases in their buildings and demand that the tenant merely pay the same as other tenants. A good tenant's broker may have been part of the negotiation of other leases in the landlord's building and may be able to point out landlord concessions on operating expenses obtained by other tenants. Each party should be sure that it is making comparisons to the right market. It would not make sense for a landlord to demand a tenant in one of its Houston buildings to pay what its tenants in New York pay (although the landlord might think so).

Conclusion

There are many other operating expenses included in the negotiation by tenants and landlords for inclusion or exclusion from the list of operating expenses. With any operating expense that is subject to negotiation, the parties should consider the following questions:

1) Is the expenditure a cost of ownership of the asset?

2) Will the expenditure reduce the cost of current operating expenses in the long run?

3) Is the expenditure a cost typically paid for by tenants in the building or in the local market?

4) Does the expenditure affect or benefit all tenants in the office building or a single tenant?

5) Is it fair or reasonable to expect the tenant to pay for the expenditure?

The list above is by no means an exhaustive list of what questions to consider during the negotiation of operating expenses. However, parties to a lease transaction can use these questions as a starting point to work out effectively and reasonably which party should bear the cost of a particular operating expense. The parties should also consider that there may be unique characteristics of a building or its operating procedures or unique business issues with a landlord or tenant that would prevent either party from advocating the positions described in this article.

Eric M. Greenberg is an associate in the Boston office of Seyfarth Shaw LLP.

With so much of today's retail space being leased in mixed-use buildings, especially office buildings, developers and retailers should familiarize themselves with leasing concepts inherent in office leases. While the inner workings of CAM charges in a shopping center are familiar territory for the developer and the retailer, the negotiation of operating expenses in an office lease poses a different sort of challenge. It is important to discuss this topic because the allocation of which party pays the costs of an office building's operating expenses is one of the most negotiated provisions in an office lease.

Naturally, a landlord will attempt to include as many items as possible in its list of building operating expenses of which tenant must pay a proportionate share, and a tenant will attempt to exclude as many of those items as it can. Negotiation of what is included and excluded in operating expenses can have a drastic effect on a tenant's (and landlord's) bottom line. What first seems like an acceptable figure for base rent may no longer look like a bargain after a landlord's laundry list of operating expenses is added to the mix. The intent of this discussion is to provide a brief overview of commonly negotiated operating expenses. This article presents both the landlord and tenant perspective for each operating expense issue discussed.

List of Exclusions

Any sophisticated tenant's broker will have a list of building expenses that are typically excluded from the list of operating expenses included in a lease form provided by a landlord. Such items will represent those building expenses that are traditionally paid for solely by the landlord in the particular market in which the building is located. A tenant should not expect that a landlord will automatically agree to exclude every item that is on such a list, but using a broker's list of suggested exclusions is a good starting point for negotiating operating expenses. Of course, those same brokers representing the tenant will have a separate list of operating expense inclusions when they are representing landlords.

Capital Expenditures

A capital expenditure is commonly defined as any expenditure that extends the life of an asset. The issue of which party bears the costs of capital expenditures is often a touchy subject since capital expenditures can be very expensive. It is a common tenant position that the cost of a capital expenditure is a cost that should be born solely by the landlord, since paying for capital expenditures is part and parcel of ownership of a building. Knowing this, a landlord will still want to include the entire range of possible capital expenditures, or alternatively, attempt to characterize certain capital expenditures as operating expenses so that it can at least pass on some of the costs of special big-ticket items purchased for the betterment of the entire office building to the tenant.

Capital expenditures that are replacements of core building systems or repairs of structural, design, mechanical, or engineering defects are usually paid for by the landlord. However, landlords often try at least to carve out certain capital expenditures to be paid for by tenants on the theory that certain capital expenditures greatly benefit the tenant and are not necessarily a cost of owning the asset. For example, landlords may demand the following to be included as operating expenses: 1) capital expenditures that are made to improve life, safety, and security features of the office building, 2) capital expenditures that are made to comply with recently enacted laws or laws that have passed but will not take effect until a future date, and 3) capital expenditures that will improve building systems and result in a decrease of the cost of operating expenses. However, if a tenant agrees to this, it should expect that the actual cost of its proportionate share of a capital expenditure will not be more than the amount the landlord expects to save as a result of the particular capital expenditure. Since bright-line standards for determining what falls under the category of capital expenditures are not easy to identify, many leases include provisions that specifically list what is and what is not a capital expenditure. The key question is whether the particular expenditure is more a cost of ownership of the asset or a cost of operating and maintaining the asset.

Replacements

Should a landlord or tenant pay for the replacement of rugs in the elevator? The replacement of a water fountain in the lobby? A landlord will argue that it should not bear the costs of replacing items that are used by tenants on a daily basis, especially since the need for the replacement was most likely necessitated by tenant usage. On the other hand, a tenant will argue that the cost of making everyday building replacements is simply a cost of ownership for the landlord (an argument that a tenant will make many times during the negotiation of operating expenses). Nevertheless, if pushed by a landlord, a tenant should try specifically to identify categories of replacements it is willing to pay for, such as: 1) replacements that cost less than a negotiated price cap; 2) replacements of common area beautification items (i.e., plants, lighting, etc.), which benefit a tenant and its guests on a daily basis, or 3) replacement of common building items which serve fundamentally practical purposes (e.g., faucets in bathrooms, water fountains, etc.).

There is a debate as to whether tenants should pay for replacements that were not purchased for the purpose of improving the replaced building function (i.e., lowering costs and providing enhanced service) but replaced because of a desire by the landlord merely to update an old building function with a new one. However, it is rather difficult to prove that a replacement item does not provide some sort of improvement over the old item. Therefore, many landlords will be reluctant to exclude replacements from operating expenses, especially in large office buildings where replacements may very well be necessary every day.

Equipment

Landlords and tenants often argue about whether equipment purchased for an office building constitutes a capital expenditure, the cost of which is borne by the landlord, or a basic operating expense, the cost of which is borne by the tenant. The parties should ask the following question: Is the purchased equipment more in the nature of an expenditure designed to extend the life of an asset or is it more in the nature of a general operating expense likely to benefit tenants immediately? For example, equipment such as a snow blower does not necessarily extend the life of the office building, but is useful in clearing pathways and entrances for tenants, which seems to fall within the category of operating expenses. On the other hand, equipment that clearly extends the life of an asset, such as a wind-stabilizing device, will more likely be characterized as a capital expenditure for which the tenant is not responsible (but query whether this falls under the life safety capital expenditure carve-out discussed above). In addition, tenants will try to exclude rental equipment that, if bought by landlord, would constitute a capital expenditure. Since it is difficult to delineate bright-line standards to determine what types of equipment should or should not be excluded from capital expenditures, parties to a lease should consider listing specific equipment to be included or excluded from operating expenses (much like how leases specifically identify capital expenditure inclusions and exclusions).

Costs Attributed to a Specific Tenant

A tenant should not have to pay for increases in the insurance costs or real estate taxes that are directly attributable to the activities of another tenant in the office building. For example, if a tenant plans to handle toxic chemicals in its premises (assuming its lease allows such a hazardous activity), the insurance for such tenant will be significantly higher than that for a tenant in the same building with comparable space that is only used for general office space. Why should the tenant using its space for general office use have to bear the costs of another tenant's dangerous activities? For this very reason, a tenant should specifically request that increases in insurance and real estate taxes directly attributable to the unique activities of another tenant should not be included in the list of operating expenses in its lease.

Artwork

Fine artwork and sculptures in the lobbies, common areas, or exteriors of office buildings can increase the social value of a building and, perhaps to a lesser degree, its economic value. At the very least, artwork can transform the cold and institutional office building environment into an engaging, lively, and pleasant one. But is it fair for tenants to share the cost of purchasing a million dollar Picasso painting? Most landlords will not expect tenants to pay for a collection of paintings that should be in the Louvre, but tenants often will bear the costs of cleaning and securing artwork purchased by the landlord. However, tenants should be careful to agree only to pay for commercially reasonable costs of securing artwork to avoid having to pay for state-of-the-art security systems only seen in the movies.

Charitable Contributions

To remain in the good graces of the community in which their buildings are located, landlords often make contributions to local nonprofits and politicians. While tenants may very well make similar contributions, tenants will most likely have an issue with paying for the philanthropic and political preferences of their landlords, especially if such preferences do not align closely with those of the tenants. As a general rule, tenants should not pay for political contributions, but should expect to pay their share of contributions to local charities or nonprofits that are committed to improving or contributing to the neighborhood or business district in which the office building is located. Where political contributions are a much more personal and individual expenditure, a donation to an entity that furthers the community where the building is located benefits not only the landlord, but also the tenant and its employees, guests, etc. However, the landlord will most likely get all of the credit for the donation. A tenant may consider requesting that the landlord provide any recipient of a donation with a list of all tenants that contributed to the donation.

Management Costs

Landlords, especially those that own more than one property, hire and rely upon professional management companies to run the everyday operations of the their buildings. Sometimes the management company is a related landlord entity, and sometimes a landlord's property manager is a third-party specialist. Since management costs and fees can be very expensive, there is plenty of negotiation over which party pays which management expenses. Tenants often pay for the costs of management expenses if the building management office is housed in the building itself. Alternatively, tenants usually do not pay the costs of overhead from management offices located outside of the building in which they occupy space.

In addition, a tenant will most likely not be responsible for the salary of an employee at a grade level higher than property manager. Landlords may try to pass on the cost of the salaries of employees who oversee the property managers and operations of various buildings owned by the landlord. This category of employee presents a tricky issue. On one hand, regional property managers provide a useful function for each building under their purview. However, tenants may find getting charged for both a property manager and a regional manager as a sort of double taxation by the landlord.

Specialty Items

What if a landlord of a large office building decides to build a day care center on the ground floor that caters both to tenants of the building and third-party customers? Or an observation deck for tourists? If the specialty service caters to third parties other than individual tenants of the landlord's building, tenants should not expect to pay for the costs of installing, operating, or maintaining such services since the landlord is most likely receiving income from those services, and the tenants are not the sole beneficiaries of the services. If, on the other hand, the landlord installs a facility solely for tenant use (e.g., exercise room without usage fees), there may be an expectation that the cost be included in the tenant's operating expenses.

Market Considerations

During the negotiation of a lease, the parties should consider how the local market treats a particular building expense ' what are other landlords including in their list of operating expenses and what are other tenants willing to pay for? Of course, regardless of what the market is dictating, landlords will want to include all building expenses that comparable landlords include in similar buildings (or what the landlord includes in its other buildings) in the calculation of tenant operating expenses, and tenants will only want to pay for what other tenants are paying. Landlords may point out other leases in their buildings and demand that the tenant merely pay the same as other tenants. A good tenant's broker may have been part of the negotiation of other leases in the landlord's building and may be able to point out landlord concessions on operating expenses obtained by other tenants. Each party should be sure that it is making comparisons to the right market. It would not make sense for a landlord to demand a tenant in one of its Houston buildings to pay what its tenants in New York pay (although the landlord might think so).

Conclusion

There are many other operating expenses included in the negotiation by tenants and landlords for inclusion or exclusion from the list of operating expenses. With any operating expense that is subject to negotiation, the parties should consider the following questions:

1) Is the expenditure a cost of ownership of the asset?

2) Will the expenditure reduce the cost of current operating expenses in the long run?

3) Is the expenditure a cost typically paid for by tenants in the building or in the local market?

4) Does the expenditure affect or benefit all tenants in the office building or a single tenant?

5) Is it fair or reasonable to expect the tenant to pay for the expenditure?

The list above is by no means an exhaustive list of what questions to consider during the negotiation of operating expenses. However, parties to a lease transaction can use these questions as a starting point to work out effectively and reasonably which party should bear the cost of a particular operating expense. The parties should also consider that there may be unique characteristics of a building or its operating procedures or unique business issues with a landlord or tenant that would prevent either party from advocating the positions described in this article.

Eric M. Greenberg is an associate in the Boston office of Seyfarth Shaw LLP.