Switching to Fixed Operating Costs

These days, it has become very common for retail landlords to charge retail tenants “pass through” costs such as operating expenses, insurance costs, taxes, and marketing costs on a fixed cost basis with mandatory fixed increases as opposed to charging tenants a proportionate share of the actual amounts for these charges. The advantage for the landlord to provide these costs on a fixed basis with fixed increases (“Fixed Costs”) is to reduce costs for accounting, reduce or eliminate tenant audit rights, and perhaps be able to make a profit, if the Fixed Costs exceed the actual costs incurred by the landlord for these expenses. The advantages to the tenant for paying these Fixed Costs (instead of a proportionate share of these expenses) is that it allows the tenant to budget for these costs with an absolute certainty as to what these costs will be in the future; it reduces accounting and audit costs, and protects the tenant in the event certain “uncontrollable costs” (e.g., taxes, energy costs, etc.) greatly increase in the future, since this risk has now been assumed by the landlord.

However, there are certain issues that a tenant should consider before agreeing to switch from paying these “pass through” expenses on a proportionate share basis to paying for these expenses as part of Fixed Costs. Among those issues that should be considered by the tenant are what expenses should be included in Fixed Costs, what expenses are excluded from Fixed Costs and how the Fixed Costs will be escalated over time.

What Expenses Are Included in Fixed Costs

In order to make the conversion to Fixed Costs a benefit to the tenant, virtually all of the additional rent expenses should be included in Fixed Costs. While the list of charges that should be included in Fixed Costs would certainly include operating expenses, taxes, marketing costs and insurance costs, the Fixed Costs should also include costs that are often aggregated under the broad category of “utilities.” Certain of these utility-type charges include trash removal, maintenance of a central heating, ventilating and air conditioning system (HVAC), replacement of HVAC equipment, pest extermination, and maintenance of the telephone and satellite communication systems that serve the retail facility. The argument for the tenant is that if this conversion to Fixed Costs is supposed to reduce accounting expenses and streamline the rent process, then those charges that would otherwise be included in maintaining the retail facility (and generally would be included in common area maintenance expenses), should likewise be included in Fixed Costs. Landlords will often argue that HVAC systems are outside the scope of Fixed Costs, but maintenance, repair, and replacement of the HVAC systems serving the retail facility are nothing more than common area maintenance expenses. Without including these items in Fixed Costs, the tenant has a wide exposure for additional rent charges that will be passed through to the tenant.

While it can certainly be argued that the energy used to run the central HVAC system should not be included in Fixed Costs (since the electrical energy in most retail leases is viewed as a utility, similar to water and gas), the actual expenses to maintain the HVAC systems are not. Therefore, a tenant should be certain that all items that are viewed as common area maintenance expenses are included in the definition of Fixed Costs.

Further, a tenant should be certain that the amount it is paying for Fixed Costs coincides with the amount that the tenant should have been paying for the “pass through” expenses at the time the conversion is made. While a landlord may seek to increase the initial amount for Fixed Costs (since the landlord is now assuming the risk for non-controllable expenses like taxes and insurance costs), the tenant should closely monitor the amounts the tenant is being billed for Fixed Costs, to be certain that the initial amount is accurate. Because the tenant will usually be forced to waive any audit rights regarding these costs, and because the amount will escalate on an annual basis by a fixed amount, the tenant needs to be certain that the initial amount being billed to the tenant is accurate, so as to avoid a situation where Fixed Costs do not bear any relation to the actual amount for such costs.

For instance, if the tenant has not performed an audit of those items included in Fixed Costs for several years, the landlord may have been improperly billing the tenant for those costs and such costs will now be incorporated into the Fixed Costs, with no oversight being permitted for the tenant. By way of example, assume the landlord has been excluding kiosks and similar merchandising units from the calculation of operating expenses prior to the conversion to Fixed Costs, but such exclusion is not permitted by the terms of the lease. A tenant will want to make certain that the tenant is not paying an inflated amount for Fixed Costs based on such improper billing that the tenant would not otherwise be obligated to pay for the tenant's proportionate share of such expenses. Similarly, assume there are certain capital items that the landlord would not have been permitted to pass through to the tenant when the tenant was paying its proportionate share of such expenses. The tenant unfortunately did not monitor this charge closely or audit this charge for prior years ' and the landlord has been passing through these capital expenses. The tenant should ensure that this inflated amount (with the capital expenses included) is not included in the amount that the tenant is now paying as part of Fixed Costs.

Accordingly, a tenant should closely monitor the components that comprise Fixed Costs before agreeing to a fixed amount as Tenant's initial charge for Fixed Costs. Also, a tenant should verify those costs that will comprise Fixed Costs and the manner in which such costs were calculated.

Items Excluded from Fixed Costs

Since landlords are assuming a great deal of risk by including all of the additional rent items in Fixed Costs, landlords typically try to defray some of the risk by excluding certain items from Fixed Costs. Tenants should strenuously resist any exclusions from Fixed Costs. The rationale for the tenant is that if a tenant is attempting to reduce accounting functions, budget appropriately for future years, and control rent expenses, a tenant should not assume any risk for expenses that may be deemed non-controllable, since that is one of the main reasons that a tenant is agreeing to convert to a Fixed Cost basis.

Certain of the costs that landlords may seek to exclude from the definition of Fixed Costs include:

• Hazardous Materials;
• Maintenance Repair and Replacement of HVAC Equipment
• Items Related to Terrorism, Including Damage, Liability, and Insurance Premiums;
• Unforeseen Insurance Increases, Liabilities, or Risks;
• Amounts Attributable to Reassessment of Taxes that Exceed Ten percent (10%) of the Prior Year's Assessment;
• Governmentally Mandated Reno- vations or Modifications to the Retail Facility; and
• Amounts Attributable to a Change in the Minimum Wage Calculation.

While all of the foregoing items can be viewed as “non-controllable” and a risk that the landlord is assuming, that assumption of risk is at the basis of converting to Fixed Costs. As a result, the tenant should not only resist excluding these items, but a tenant should consider even increasing the initial amount for Fixed Costs, rather than excluding the foregoing items from the calculation of Fixed Costs.

Additionally, a tenant should attempt to avoid having to reconcile additional rent charges for the period of time prior to the conversion to Fixed Costs. If one of the reasons the tenant is agreeing to convert to Fixed Costs is to reduce the tenant's accounting functions, then having to reconcile additional rent charges a year or more after the conversion to Fixed Costs has occurred, will merely occupy time for the tenant's staff to perform this function. While it could be argued that the tenant is leaving money on the table by not reconciling these additional rent charges (which may have been overestimated by the landlord when being billed through to the tenant), it could also be argued that the tenant is already assuming these risks by converting to a billing based upon Fixed Costs. For instance, each year that the tenant is paying the Fixed Costs, the actual costs may be less than the amount that the tenant is paying for Fixed Costs. As a result, once the tenant has agreed to assume this risk of perhaps being slightly overbilled in excess of the Fixed Costs, it would seem to follow that ending reconciliations as of the time the tenant is converting to Fixed Costs, would make sense from an administrative standpoint.

Further, by agreeing not to reconcile charges, the tenant would be prevented from being back-billed for an amount that the landlord has failed or neglected to bill to the tenant, at a time when the landlord had the ability to pass such charge through to the tenant (e.g., the landlord determines that the landlord has under-billed insurance costs going back several years, and the landlord seeks to pass this insurance cost through to the tenant).

Escalation of Fixed Costs

While it is difficult to determine exactly how much Fixed Costs should increase each year, the percentage by which the Fixed Costs will be increased should not be necessarily uniform throughout the country. A tenant should closely analyze those expenses that it is paying in the area of the country in which the retail facility is located in order to determine the appropriate percentage by which Fixed Costs should be escalated for that particular facility. Since the amount that the tenant is paying in Fixed Costs over time will not be subject to audit or oversight by the tenant, a careful examination of the percentage by which the Fixed Costs will be escalated is critical, so that the Fixed Costs are not simply turned into a profit center for the landlord. An annual 3% to 5% escalation these days is typical.

Conclusion

By carefully analyzing those items that are included in Fixed Costs, those items that are excluded from Fixed Costs, and the manner by which Fixed Costs will be escalated each year, a tenant can effectively convert from the payment of a proportionate share of additional rent expenses to the payment of a Fixed Cost expense, without unreasonably increasing the tenant's overall rent or substantially overpaying for common area maintenance expenses.

Glenn A. Browne, a member of this newsletter's Board of Editors, is a shareholder in the law firm Braun, Browne & Associates, P.C., Riverwoods, IL. Mr. Browne's law practice is concentrated in the areas of purchase and sale of real estate, commercial leasing and lease-related matters.

These days, it has become very common for retail landlords to charge retail tenants “pass through” costs such as operating expenses, insurance costs, taxes, and marketing costs on a fixed cost basis with mandatory fixed increases as opposed to charging tenants a proportionate share of the actual amounts for these charges. The advantage for the landlord to provide these costs on a fixed basis with fixed increases (“Fixed Costs”) is to reduce costs for accounting, reduce or eliminate tenant audit rights, and perhaps be able to make a profit, if the Fixed Costs exceed the actual costs incurred by the landlord for these expenses. The advantages to the tenant for paying these Fixed Costs (instead of a proportionate share of these expenses) is that it allows the tenant to budget for these costs with an absolute certainty as to what these costs will be in the future; it reduces accounting and audit costs, and protects the tenant in the event certain “uncontrollable costs” (e.g., taxes, energy costs, etc.) greatly increase in the future, since this risk has now been assumed by the landlord.

However, there are certain issues that a tenant should consider before agreeing to switch from paying these “pass through” expenses on a proportionate share basis to paying for these expenses as part of Fixed Costs. Among those issues that should be considered by the tenant are what expenses should be included in Fixed Costs, what expenses are excluded from Fixed Costs and how the Fixed Costs will be escalated over time.

What Expenses Are Included in Fixed Costs

In order to make the conversion to Fixed Costs a benefit to the tenant, virtually all of the additional rent expenses should be included in Fixed Costs. While the list of charges that should be included in Fixed Costs would certainly include operating expenses, taxes, marketing costs and insurance costs, the Fixed Costs should also include costs that are often aggregated under the broad category of “utilities.” Certain of these utility-type charges include trash removal, maintenance of a central heating, ventilating and air conditioning system (HVAC), replacement of HVAC equipment, pest extermination, and maintenance of the telephone and satellite communication systems that serve the retail facility. The argument for the tenant is that if this conversion to Fixed Costs is supposed to reduce accounting expenses and streamline the rent process, then those charges that would otherwise be included in maintaining the retail facility (and generally would be included in common area maintenance expenses), should likewise be included in Fixed Costs. Landlords will often argue that HVAC systems are outside the scope of Fixed Costs, but maintenance, repair, and replacement of the HVAC systems serving the retail facility are nothing more than common area maintenance expenses. Without including these items in Fixed Costs, the tenant has a wide exposure for additional rent charges that will be passed through to the tenant.

While it can certainly be argued that the energy used to run the central HVAC system should not be included in Fixed Costs (since the electrical energy in most retail leases is viewed as a utility, similar to water and gas), the actual expenses to maintain the HVAC systems are not. Therefore, a tenant should be certain that all items that are viewed as common area maintenance expenses are included in the definition of Fixed Costs.

Further, a tenant should be certain that the amount it is paying for Fixed Costs coincides with the amount that the tenant should have been paying for the “pass through” expenses at the time the conversion is made. While a landlord may seek to increase the initial amount for Fixed Costs (since the landlord is now assuming the risk for non-controllable expenses like taxes and insurance costs), the tenant should closely monitor the amounts the tenant is being billed for Fixed Costs, to be certain that the initial amount is accurate. Because the tenant will usually be forced to waive any audit rights regarding these costs, and because the amount will escalate on an annual basis by a fixed amount, the tenant needs to be certain that the initial amount being billed to the tenant is accurate, so as to avoid a situation where Fixed Costs do not bear any relation to the actual amount for such costs.

For instance, if the tenant has not performed an audit of those items included in Fixed Costs for several years, the landlord may have been improperly billing the tenant for those costs and such costs will now be incorporated into the Fixed Costs, with no oversight being permitted for the tenant. By way of example, assume the landlord has been excluding kiosks and similar merchandising units from the calculation of operating expenses prior to the conversion to Fixed Costs, but such exclusion is not permitted by the terms of the lease. A tenant will want to make certain that the tenant is not paying an inflated amount for Fixed Costs based on such improper billing that the tenant would not otherwise be obligated to pay for the tenant's proportionate share of such expenses. Similarly, assume there are certain capital items that the landlord would not have been permitted to pass through to the tenant when the tenant was paying its proportionate share of such expenses. The tenant unfortunately did not monitor this charge closely or audit this charge for prior years ' and the landlord has been passing through these capital expenses. The tenant should ensure that this inflated amount (with the capital expenses included) is not included in the amount that the tenant is now paying as part of Fixed Costs.

Accordingly, a tenant should closely monitor the components that comprise Fixed Costs before agreeing to a fixed amount as Tenant's initial charge for Fixed Costs. Also, a tenant should verify those costs that will comprise Fixed Costs and the manner in which such costs were calculated.

Items Excluded from Fixed Costs

Since landlords are assuming a great deal of risk by including all of the additional rent items in Fixed Costs, landlords typically try to defray some of the risk by excluding certain items from Fixed Costs. Tenants should strenuously resist any exclusions from Fixed Costs. The rationale for the tenant is that if a tenant is attempting to reduce accounting functions, budget appropriately for future years, and control rent expenses, a tenant should not assume any risk for expenses that may be deemed non-controllable, since that is one of the main reasons that a tenant is agreeing to convert to a Fixed Cost basis.

Certain of the costs that landlords may seek to exclude from the definition of Fixed Costs include:

• Hazardous Materials;
• Maintenance Repair and Replacement of HVAC Equipment
• Items Related to Terrorism, Including Damage, Liability, and Insurance Premiums;
• Unforeseen Insurance Increases, Liabilities, or Risks;
• Amounts Attributable to Reassessment of Taxes that Exceed Ten percent (10%) of the Prior Year's Assessment;
• Governmentally Mandated Reno- vations or Modifications to the Retail Facility; and
• Amounts Attributable to a Change in the Minimum Wage Calculation.

While all of the foregoing items can be viewed as “non-controllable” and a risk that the landlord is assuming, that assumption of risk is at the basis of converting to Fixed Costs. As a result, the tenant should not only resist excluding these items, but a tenant should consider even increasing the initial amount for Fixed Costs, rather than excluding the foregoing items from the calculation of Fixed Costs.

Additionally, a tenant should attempt to avoid having to reconcile additional rent charges for the period of time prior to the conversion to Fixed Costs. If one of the reasons the tenant is agreeing to convert to Fixed Costs is to reduce the tenant's accounting functions, then having to reconcile additional rent charges a year or more after the conversion to Fixed Costs has occurred, will merely occupy time for the tenant's staff to perform this function. While it could be argued that the tenant is leaving money on the table by not reconciling these additional rent charges (which may have been overestimated by the landlord when being billed through to the tenant), it could also be argued that the tenant is already assuming these risks by converting to a billing based upon Fixed Costs. For instance, each year that the tenant is paying the Fixed Costs, the actual costs may be less than the amount that the tenant is paying for Fixed Costs. As a result, once the tenant has agreed to assume this risk of perhaps being slightly overbilled in excess of the Fixed Costs, it would seem to follow that ending reconciliations as of the time the tenant is converting to Fixed Costs, would make sense from an administrative standpoint.

Further, by agreeing not to reconcile charges, the tenant would be prevented from being back-billed for an amount that the landlord has failed or neglected to bill to the tenant, at a time when the landlord had the ability to pass such charge through to the tenant (e.g., the landlord determines that the landlord has under-billed insurance costs going back several years, and the landlord seeks to pass this insurance cost through to the tenant).

Escalation of Fixed Costs

While it is difficult to determine exactly how much Fixed Costs should increase each year, the percentage by which the Fixed Costs will be increased should not be necessarily uniform throughout the country. A tenant should closely analyze those expenses that it is paying in the area of the country in which the retail facility is located in order to determine the appropriate percentage by which Fixed Costs should be escalated for that particular facility. Since the amount that the tenant is paying in Fixed Costs over time will not be subject to audit or oversight by the tenant, a careful examination of the percentage by which the Fixed Costs will be escalated is critical, so that the Fixed Costs are not simply turned into a profit center for the landlord. An annual 3% to 5% escalation these days is typical.

Conclusion

By carefully analyzing those items that are included in Fixed Costs, those items that are excluded from Fixed Costs, and the manner by which Fixed Costs will be escalated each year, a tenant can effectively convert from the payment of a proportionate share of additional rent expenses to the payment of a Fixed Cost expense, without unreasonably increasing the tenant's overall rent or substantially overpaying for common area maintenance expenses.

Glenn A. Browne, a member of this newsletter's Board of Editors, is a shareholder in the law firm Braun, Browne & Associates, P.C., Riverwoods, IL. Mr. Browne's law practice is concentrated in the areas of purchase and sale of real estate, commercial leasing and lease-related matters.