What’s Going on with my Real Estate Operating Expenses? The Experts Weigh-in

by Marc Betesh and Jason Aster

Landlords and tenants are struggling to reconcile 2020 building operating expenses and service charges in an atmosphere of highly irregular occupancy and operational adjustments.

©Matthias Lindner/iStock/Getty Images Plus

The pandemic has had obvious and diverse implications on the way we reimagine the workplace, and the media has not missed an opportunity to regale the industry with dramatic predictions of the future of work. While these are more exciting and material changes, they have overshadowed a smaller, albeit important, financial consideration. While the C-Suite looks to optimize space and spend, and finance adjusts to ASC 842 and IFRS 16, landlords and tenants are currently struggling to reconcile 2020 building operating expenses and service charges in an atmosphere of highly irregular occupancy and operational adjustments.

What Happened?

Since landlords established their 2020 estimated operating budget in 2019, before anyone was aware of the impact COVID-19, many 2020 expense estimates and cost assumptions affected by physical building occupancy have likely missed the mark. Landlords are now faced with reconciling 2020’s estimated payments by tenants with actual 2020 obligations.

This presents several issues. They must resolve if, why and how to adjust 2020 expenses that vary with occupancy, and must figure out how to account for and bill unplanned capital improvement projects that were put in place to address health and safety concerns. The effect of such confusion is that tenants won’t know if their landlords’ calculations are correct. If they are given a credit, is it an accurate amount? If they are asked to pay more to cover a 2020 OpEx shortfall, is it too much?

Where’s the Confusion?

Sunny Patel, Head of Real Estate at National Fitness Partners (one of the largest Planet Fitness Franchisees), noted that there is “not a standard definition for occupancy.” When expenses are directly correlated with building occupancy, we have to consider both the amount of the building leased by tenants and the number of people actually in the building using its resources. In this context, “normal” occupancy and use become subjective. Pairing this subjective measure with the unconventional occupancy variations and reactive building improvements spurred by COVID-19, results in widespread confusion around the determination of tenants’ liabilities for CAM and OpEx charges. Simply put, there’s a lot to keep track of, which is where dedicated technology – such as a centralized system for lease data management – can be particularly helpful.   

What to Look Out For

The first item to consider is capital expenditures. David Tevlin, SVP, Enterprise Solutions at Fisher, cautions that tenants should look out for improvements and installations made in response to COVID-19 that are of a permanent nature, such as enhanced security desks and systems, touchless modifications to door/elevator systems and HVAC filtration systems. Depending on the provisions specific to each lease, tenants may, or may not, be responsible for these costs in the year they are incurred, or only exposed to the annual amortization expense over the useful life of such new installations/improvements. There are hundreds of different lease provisions, each designed to uniquely control the what, when, why and how around allowable capital projects (i.e., when are they chargeable to the tenant), so it’s important to know what to look out for.

Echoing these sentiments, Patel suggests that all tenants should ascertain their expense cap limits and record them in their lease administration database, as these caps may offer partial protection from such increases. However, Tevlin notes that landlords will likely argue that “no limitation should be applied as the cost increases are out of their control.”

“Gross-up” Calculations

Legally, there is a well-known and relatively technical convention that could result in complex calculation errors – the “gross up” provision. Consider this: because building expenses are aggregated and then divided up among the tenants, when buildings have vacancies, leases often permit landlords to artificially adjust costs to what they would have been had the building been full so that the remaining tenants do not receive a windfall (this usually only affects those expenses that vary with occupancy, although the impact of reduced occupancy in 2020 may stress the logical limits of this concept). Grossing-up expenses is appropriate when less space is leased in a building, leaving more vacant rentable square footage requiring less service. However, increasing expenses to “normal” operating levels may not be fair when the space is actually occupied, but the tenants don’t physically show up to the office and don’t use the building’s services.

Even under normal circumstances, it can be hard for landlords to gross-up correctly. And, as landlords need to adjust their calculations to each lease during the highly unorthodox, minimal building occupancy of 2020, we can expect even further complications to arise in the accurate billing of tenant liability.

Understated Base Year Leases

In certain leasing markets like New York City and other metropolitan areas, it is common for leases to be structured with base years. In these leases, the rent incorporates the initial cost of operating the building in the first or “base” year of the lease, and requires the tenant to pay for expense increases that occur in subsequent years.  

In normal circumstances, there is a lot of complexity to establishing a base year that reasonably represents the total cost of operating a fully-occupied building. Given the unusual circumstances surrounding occupancy and utilization during 2020 and 2021 (so far), tenants with 2020 or 2021 base years need to be particularly vigilant. The base year expenses and assumptions made in 2020 and 2021 will need to be closely scrutinized by an experienced lease audit firm that has legal, forensic accounting and building operations experts. Their input can help ensure the expense level is a fair representation of the costs necessary to operate the building for the remainder of the lease term. Leases with base years established in a year with such an aberrational cost pattern will likely suffer from understated expense assumptions that will plague a tenant’s escalation liability for the entire lease term.

Be Prepared to be Fluid

Although a lease is intended to create a somewhat static and predictable relationship, situations like COVID-19 show us how fluid the occupancy lifecycle can be. There are countless unforeseen circumstances that neither landlord nor tenant could contemplate when the lease was executed. Therefore, it is critical to evaluate the financial effects of COVID-19 in the context of the unique provisions agreed to in each lease so that the parties can reach an equitable resolution to any matters that may arise.

Creating a conservative and well-considered approach that respects the many facets of lease language, financial treatment and building mechanics is especially important this year. The rigor and sophistication that is required to draft and execute the deal should be applied in equal measure to interpret and resolve any potential issues that crop up during the term of the lease.

Marc Betesh is the President and Founder of Visual Lease and KBA Lease Services. Jason Aster is the Managing Director at KBA Lease Services.