The need to be diligent about escalation clauses and their impact on long-term budgeting is best illustrated by the following story.
Not too long ago, I was representing an office tenant that was experiencing “sticker shock” when reviewing a proposal to renew the lease. The proposal from the landlord was for a new five-year term lease. The proposed rent was $27.00 per square foot. Each of the partners in the firm loved the space. It was a good building, with excellent road and rail access, just half an hour from the airport, convenient for clients and employees. But to pay $27.00 PSF! Impossible. They had moved there seven years earlier during a slow period in the real estate market and started out paying just $22.00 per square foot. The partners were concerned about affording a $5.00 per square foot rent increase. They were even wondering if they should be moving to a lower quality building in a marginal location to keep costs down, although a move can be quite expensive in itself.
But the story has a happy outcome. When I reviewed their current rent, I found that over the seven years their rent, triggered by escalation clauses, had been escalating each year by about a $1.00 PSF. While the partners were aware of how much the base (initial rent) quoted in the lease was, they never looked at a recent bill to recalculate what they were currently paying in rent. The effect over the years of accumulated escalations on their rent had actually raised their current rent to $29.00 PSF. Thus, the rent proposed by the landlord for the new lease was $2.00 PSF less than the current rental they were already paying. While the accounts payable manager of the company knew the current rate, none of the decision making partners had any idea that each year the rent had been slowing increasing. Of course, they decided to stay and renew the lease.
It should come as no surprise that the cost of operating and maintaining an office building will increase over time. The good news is that, during the last few years, inflation has been relatively low and, as a result, operating costs have been relatively stable.
In a typical gross office lease, the tenant is responsible for paying his proportionate share of the increases in building operating expenses over and above the base year.
Let’s define some terms used above. The base year for operating expenses is defined as the operating expenses that occur during the first year of the lease. The base year may be further defined as the expenses that occur during the first 12 months of the lease term or the expenses that occur during a specific calendar year, or any agreed upon 12 month period.
For example, if a building’s operating expenses are $5.00 per square foot at the commencement of a lease and operating costs increase or escalate to $5.50 per square foot a year later, the tenant is responsible for paying the landlord an increase in rent of $.50 per square foot starting in the second year. In this way, the landlord is able to keep up with the increasing cost of maintaining the property. In return, the tenant is assured that the landlord will keep up the quality of building services over the term of the lease.
In the case of a newly constructed building, the landlord may estimate the expense for the base year. This is known as an expense stop. That is a point where the landlord’s expenses stop and yours, the tenant’s, begin.
For example, let’s assume that the landlord, based upon his “sophisticated” projections, estimates that operating expenses for his new building should be $4.50 per square foot during the first year of the lease. What if when the building is completed, the expenses really turn out to be $5.50 per square foot during that first year? Oh well, the landlord guessed wrong! You, the tenant, now have a hidden increase in rent of $1.00 per square foot.
Secret No. 10 — When leasing space in a new building, try to agree to adjust the base year amount to the amount of actual expenses that occur during the first year. These expenses can only be determined after the building is constructed. Don’t you assume the risk. As a tenant, you have absolutely no control over the outcome.
Now, let’s imagine that you are a new tenant moving into a building that is only 50% occupied at the time your company moves in. It is now two years later and the building is fully occupied. The landlord sends you an escalation bill. He states that the building’s operating expenses have doubled to handle the increasing cost of providing building services to all the new tenants. Wait a minute! Is that fair?
Secret No. 11 — The base year amount for operating expenses should be increased to project the operating expenses as though the building were at full occupancy (usually defined as 95% or 100%). In this way, the tenant will be responsible only for true increases in the cost of operating the building, not the increasing costs of providing services to a greater number of tenants.
The lease usually includes a list of items that are part of the operating expense statement. Here is a sample list:
- Operating, repairing, cleaning, removing snow, ice, garbage and debris, policing and regulating traffic and depreciation of machinery and equipment used for such operations;
- Repairing, maintaining and/or replacing paving, curbs, walkways, landscaping (including replanting and replacing flowers and other planting) and drainage and lighting facilities, other than those of a capital nature;
- Electricity, fuel, water and all other utilities used in lighting, heating, ventilating, air-conditioning or otherwise servicing the building, and not charged to tenant;
- Maintenance, repair and/or replacement of all mechanical and electric equipment, including heating, ventilating and air-conditioning equipment in or related to the building;
- Window cleaning and janitorial service, including equipment and supplies, in and around the building and lands;
- Maintenance, repair, painting, decoration and carpeting of elevators, rest rooms, lobbies, hallways and all other common and public areas of the building and lands;
- All insurance premium costs incurred by landlord in connection with obtaining and maintaining fire, extended coverage and all risk insurance; rental insurance sufficient to include both fixed rent and additional rental; sprinkler damage insurance; public liability insurance; and such other insurance coverages as landlord may deem necessary or desirable; all of which insurance coverages, if maintained, shall be in such amounts with such companies as landlord may deem reasonable or proper;
- Management fees, commissions, wages and salaries of all persons engaged in the maintenance, leasing and operation of the building and lands;
- All other expenses which would be considered as an expense of maintaining, operating or repairing the building and lands in accordance with the sound accounting principles or in the performance by landlord of its obligations or in the exercise of its rights hereunder. The following are specifically excluded from the additional rent formula:
- Salaries of executive personnel employed by landlord for positions above the level of building manager;
- Costs associated with defects in the original construction of the building;
- Legal fees for negotiating leases and for instituting legal proceedings against tenants;
- Costs for capital expenditures should be limited to depreciation of any such item and not in excess of any actual savings resulting from the capital item;
- The fair rental value of office space occupied by the landlord;
- Interest or amortization expense on debt service;
- Ground rents, if any;
- Franchise, income transfer, estate, inheritance, succession and capital levy taxes or any other taxes based upon the income of the landlord;
- The cost to landlord any work or service performed in any instance of the exclusive benefit of other tenants or for which landlord is insured; and
- Costs associated with refinancing the building or the building grounds.
Secret No. 12 — Review the landlord’s expense statement carefully. Look for management fees that may be inflated. Compare each item against the statement from the year before to see which items are extraordinary or have increased at a suspicious rate. Ask questions. Have the right to examine the landlord’s books. Have a time period to dispute the expenses. Be thorough. Read all escalation statements carefully.
Real Estate Tax Escalation
Like operating expense escalation, landlords typically pass along increases in real estate property taxes. The base year for real estate taxes may be defined either as the amount of real estate taxes that occur on the property during a specific fiscal year, or taxes imposed during the first 12 months of the lease term, known as the first lease year.
Secret No. 13 — If the building is new, insist that the base year amount for real estate taxes be based on the first year the building is fully-assessed as a completed building. A landlord may sometimes get a tax credit during the first year or several years following construction. He may even get a credit each year for paying the tax early. Ask the landlord for a copy of each receipted tax bill.
It is generally assumed that the landlord is not entitled to make a profit on the tenant’s electricity usage. After all, he is not a public utility. The landlord insists he should not lose money based on the tenant’s electric usage either. The lease will specify that the landlord is entitled to an increase in rent if utility rates increase or if there is an increase in the tenant’s electric consumption.
Typical methods of measuring the consumption of electricity by a tenant are:
- The survey method. The survey method calculates usage based upon a survey completed by the landlord’s electrical consultant of the tenant’s equipment and hours of operation and a calculation of peak usage, as electricity costs will vary at different times of the day.
- Sub-meter. A sub-meter can be installed to monitor the tenant’s electric usage and the charges are passed on to the tenant.
- Direct meter. The tenant pays the electric charges directly to the public utility based upon its record of usage.
- Proportionate share. Some landlords charge tenants a proportionate share of electricity costs based upon their proportionate share of the total building’s electricity costs.
Secret No. 14 — Be careful if you are agreeing to pay a proportionate share of the building’s electricity charges. Know who the other tenants are and how much electricity they consume. You don’t want to get stuck with an unfair portion of another tenant’s electric bills.
Consumer Price Index (CPI)
In the days of high inflation, instead of an operating expense clause, landlords were escalating the rent based upon the increases in the consumer price index (CPI). CPI escalation works like this. For each one percent increase in CPI over the base year, rent increases by one percent. Landlords like its simplicity.
CPI escalation can be very volatile should inflation suddenly return. An argument can be made that the CPI index does not really reflect the landlord’s true cost of maintaining a building since the CPI index includes many costs which are unrelated to real estate, such as medical and hospital costs, agriculture, manufacturing, etc. I recommend to my clients that they avoid escalation charges based upon indices that do not relate directly to the landlord’s costs for the specific property.
Porters Wage Escalation
One of the greatest hidden profit centers for a landlord is the notorious porters wage escalation, which is found mostly in New York City leases. Penny-for-penny, porters wage escalation works like this. For each 1 cent per hour the hourly wage negotiated by the Porters Union in New York City Local 32-J increases, the tenant’s rent increases by an equivalent 1 cent per square foot. That’s why New York City has the highest paid porters in the nation. This type of escalation may even include the porters fringe benefits negotiated with the Union. Back in the 1970’s, it was common to see a penny and one-quarter per penny and a penny and one-half per penny escalation clauses in New York City leases. Rents were doubling every three years. Does this sound outrageous? Let the buyer beware.
Most escalation clauses are triggered on an annual basis. Once the increases have been calculated, the difference is invoiced or credited to the tenant and must be paid by or reimbursed to the tenant within an agreed number of days. The monthly rent may then increase annually thereafter. Many landlords will estimate next year’s increases and include projected escalation charges into the rent and they will divvy up the difference with the tenant at the end of each year.
Secret No. 15 — For major office leases, you may wish to hire a professional lease auditor to examine the expenses. Many auditors work on a percentage of the savings they find, so you can’t lose.
Categorised in: Escalation