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What does a Landlord mean when they say, 'Operating Expenses?'
Topics: Commercial Real Estate
Operating Expenses (OpEx), is a term commonly thrown around by Landlords, usually when discussing your monthly rent and what is included in it.
Very simply, these operating expenses are the cost for the landlord to run the building.
The question is what exactly are in these Operating Expenses? These can include but are not limited to:
- Costs and expenses paid by Landlord for maintenance or repair of the building and grounds
- Landscaping and grounds maintenance
- Cleaning and janitorial costs
- Wages and salaries of the maintenance staff
- Legal and accounting expenses, usually when refuting/seeking reductions in real estate taxes
- Management fees and administrative expenses
- Security service costs
- Amortized capital expenses
- Seasonal decorations (Yes, your rent pays for that Christmas Tree in the lobby)
The reason the expenses the landlord incurs in operating the building is important to you as a tenant is because many leases include clauses that allow for a landlord to “pass through” their costs to a tenant if the costs are over a certain amount. This protects the landlord from signing a lease at a certain return level and this return becoming diminished if there is a sudden increase in operating expenses.
There are a few ways landlords typically pass-through operating expenses, but two of the most common ways include:
Base Year – Usually the first full year of the lease term, a “Base Year” establishes what the operating expenses are in the building. Should the operating expenses increase the next full year after the base year, the tenant will pay their pro-rata share of the increases. As an example, if the base year is 2017 and the operating expenses are $100,000, and at the end of 2018 the operating expenses rose to $110,000, the tenants in the building would all pay their pro-rata share of the $10,000 increase based upon their square footage within the building.
Expense Stop – An expense stop operates much like a base year, but there is no established base year. The landlord provides historical data that paints a picture of the operating expenses and there is an established dollar amount based on this data that the Landlord bases their “Expense Stop” on. If the expense stop is $100,000, and the next year the OpEx is $110,000, it would be much like the Base Year scenario.
Now that you know some of how operating expenses come into play, many Tenants are curious what they can do to limit their exposure. A good Tenant Representative can help you negotiate with a Landlord for an “Expense Cap”. This ensures that the Tenant would not be off the hook completely for any increases in OpEx, but if they set an Expense Cap at 4% and the OpEx increases by 10%, the Tenant would only be responsible for 4% of their pro-rata share of the property.
Landlords all operate in different ways and with different expenses. Make sure when preparing to sign a lease that you are aware of what is included in the Operating Expenses and that you work to limit your exposure to any potential increases. In the world of small businesses, anything that affects the bottom line matters.
James Lomax is a Commercial Real Estate Broker with Colliers International in Huntsville, Alabama. He can be reached at 256.503.6088.