In commercial real estate leases the costs of ownership are generally passed through to the tenant in one form or another depending on the rental structure of the lease. These costs of ownership include operating expenses otherwise known as common area maintenance (CAM), real estate taxes, and insurance. Utilities can be included under operating expenses in full service (gross) leases, but are generally paid directly by the tenant in net leases.
So, what does this mean in practice? Basically, when landlords agree to a specific rental rate they are doing so with certain protections that ensure that they will continue to receive that minimum base amount plus annual escalations.
Because the costs of ownership are charged directly to the tenant (independent of the base rent) in net leases, pass-throughs (for the purposes of this conversation) are generally only applicable in full service or gross leases.
In full service leases, the costs of ownership are included in the base annual rent. The expenses in the first year of occupancy set the baseline for the remainder of the term (referred to as Base Year expenses). If these expenses increase in subsequent years the tenant is required to pay the amount of said increase based on their proportionate share of the building or center. While increases in expenses are shown as dollar amounts on a landlord’s balance sheet they are expressed in per square foot terms for the tenant. For example, if costs of ownership for a 10,000 sf building increase from $100,000 to $110,000 (an increase of $10,000) the amount charged to the tenant is expressed as an additional $1.00/sf/yr.
While tenants are always responsible for increases in pass-throughs they do not necessarily get to benefit from a reduction in the costs of ownership. If the base year expenses were $8.00/sf/yr and they decrease to $7.50/SF/yr in year 2 the tenant will simply not be charged any additional rent as opposed to enjoying a $0.50/sf/yr credit. Tenants can try and negotiate such terms but landlords are generally not amenable to such a concession.
Another means of taking advantage of decreases in expenses is by negotiating pass-throughs being charged on a cumulative basis. For example, if the base year expenses were $5.00/sf/yr for CAM, $1.50/sf/yr for real estate taxes, and $0.50/sf/yr for insurance they equal $8.00/sf/yr on a cumulative basis. Many landlords will prefer to charge the tenant for these expenses separately though so that they can benefit from any increases to one expense despite decreases in another. For example, if CAM charges increased by $0.50/sf/yr to $5.50/SF/yr but real estate taxes decreased by $0.50/sf/yr to $1.00/SF/yr the landlord would be able to charge the tenant an additional $0.50/sf/yr for CAM even though the overall expenses stayed the same at $8.00/sf/yr. By negotiating pass-throughs being charged on a cumulative basis the tenant would not be charged anything because the total charges saw a net zero increase.
Depending on the length of a lease term, the spread between a property’s base year expenses and those at the end of the lease term can be significant and have quite an impact on the effective rental rate. There are methods to mitigate this exposure and it is always a good practice to request a history of a property’s expenses to get an idea of how well the building is managed, how much expenses might increase in subsequent years, etc.
As always, when negotiating lease terms it’s recommended to seek the advice of a commercial real estate professional. For more information, questions, or representation services please contact Ryan Rauner at email@example.com or 703-943-7079.