Are You Ready for Escalation?

February 12, 2015 5:43 pm

At the end of each year, Landlords send tenants a holiday present of a different form— an escalation invoice. What is escalation you ask?

Most of you with gross office leases know what an escalation bill looks like. It is that complicated invoice that arrives from the Landlord for increases in Operating Expenses and Real Estate Taxes, and maybe Utilities. What most of you may not know is how to tell if the numbers are correct and whether you are responsible according to the lease to pay it.

Let’s start with the theory of escalation and how it works. In a typical office lease, the first year of the lease term, or most likely the first calendar year of the lease term, is defined the base year. Amounts paid by the Landlord for Operating Expenses and Real Estate Taxes in that period make up the Base Year Amount. Tenants are responsible for paying increases in Operating Expenses and Real Estate taxes above the defined Base Year. In this article, let’s start by discussing Operating Expenses.

Operating Expenses are simply defined as those expenses that the Landlord has incurred operating a building, such as building maintenance, landscaping, repairs and replacements of the HVAC system, janitorial services, repairs to the roof and structural portions of the building, the parking lot and the costs of running the building for administrative staff, insurance of the Landlord, etc. The complete list may go on for several pages.

If, for example, the Operating Expenses for the Base Year were $7.00 per square foot and the next year the Operating Expenses of running the building increased to $7.50 per square foot, you the tenant would be responsible for your proportionate share of the increases, or an increase in the rent of $.50 psf.

Sounds simply, right? As usual, everything is simple if you know the right questions to ask. Most tenants just don’t know where to start when reviewing an escalation invoice. They ask their lawyer, do we have to pay this? Yes, says the lawyer. They ask their accountants, does this statement look correct to you? Sure, it all adds up properly, the accountant says. So, what’s the problem? The devil, as they say, are in the details.

Let’s go through some of the subtleties and you will start to understand why this may not be so simple.

Capital Expenses- One of the items in the Operating Expense statement is comprised of capital expenses and repairs. Let’s break these apart even further.

Capital repairs are those repairs required to replace equipment and other building systems that may break and need to be replaced. Some of these items can be very expensive. For example, if a building HVAC unit needs to be replaced, which they do every 10 or 20 years, the amount of the repairs can be very high, running into the hundreds of thousands of dollars. The question to ask is how this cost is defined? Are you paying for the increase in the year that it occurs, or over the useful life of the replacement unit, 1/20th of the cost?

Capital Expenses can be even muddier. A Capital Expense can be replacing a lobby ceiling with gold leaf. If your Landlord did this, would you want to pay for it? If the Landlord decides to put in a whole new botanical garden in the back, do you have to pay for it?

Where to start? Start by asking for a breakdown of the Operating Expense by category so that you can compare the categories line by line against the Base Year amount so that you can see where expenses have increased. Ask questions. Why did your outside lighting bill go up by 40 percent this year? Why are snow removal charges so high when there were no snow storms last winter? If something doesn’t look right, ask. Be polite, but certainly don’t just pay the bill if you have no idea what is in it.

For my larger clients, I sometime recommend hiring an expert to do an audit. There are specialists out there that will audit these escalation statements for a portion of the savings they can find you.

If you have questions and you don’t know where to turn, give us a call. We know the right questions to ask.


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