Operating Expenses and Your Lease – The Golden Opportunity to Maximize Savings

Don’t Let Rental Rates and Landlord Concessions in your lease negotiations lull you to sleep.

Lease management
Exis Blog Post

Negotiating on your rental rate and landlord concessions are clearly important elements of any lease, but a common mistake that tenants and ineffective brokers make is over-focusing on those terms and practically ignoring other lease clauses that – if not negotiated effectively – will end up costing the tenant tens or hundreds of thousands, or even more, over the life of the lease.

A key provision which many brokers tend to under-emphasize, and landlords too often succeed in turning into an additional profit center, is the definition and treatment of operating expenses. If poorly negotiated, this section of the lease can make a landlord richer while crippling a tenant slowly over time. For this reason, terms dealing with operating expense calculations and definitions are the number one money saving clauses to negotiate aggressively besides your rent or concessions.

In this two-part series, we will focus contextually on Base Year Office leases, but much can also apply to Office NNN leases and even some Industrial NNN leases. This writing is not intended to be exhaustive or comprehensive and should not be relied upon as legal advice or even real estate advice for your specific situation. As always, I encourage you to engage a vetted “tenant-only” broker from a “tenant-only” firm and an experienced real estate attorney as part of your real estate team prior to engaging in the process leading to a lease transaction of any kind. This writing is more technical than my usual, and starts with defining operating expenses, so buckle up… let’s go!


Operating Expense Definition – This is where the rubber meets the road. When the landlord is calculating operating expenses, this portion of the lease will dictate what is and isn’t allowed in the calculation, and will be relied upon should a dispute arise. This language should be thorough, concise, and clear.

What should be included and excluded in Operating Expenses?

This topic alone could be covered in several blogs, and the purpose of this writing is to highlight some of the biggies and to alert you to the importance of hiring a good broker and real estate attorney to help negotiate legal and market-appropriate terms when it comes to these provisions in your lease.  Therefore, this list is not intended to be exhaustive, but will simply highlight some of the more important items. Please also keep in mind that there are items that are acceptable operating expenses in one region that may not be in another. For example, snow and ice removal in Phoenix is not an acceptable operating expense, while it most certainly is in Chicago.

Generally, the operating expense definition should include items which are appropriately associated with the cost of operating the office building; this could include the real estate taxes, utilities, insurance, management, maintenance, repair of the building, project, and premises. The following are a few examples of what should be excluded from the operating expense definition in a lease (consult with your tenant broker for a complete overview):

  • Tenants should exclude the cost of Capital Improvements, Capital Expenditures, Capital Repairs, and Structural changes made to the building or property. Assuming these repairs, improvements, expenditures or structural changes are original to the building and in the mortgage, the benefits of those capital improvements will benefit the landlord far beyond the expiration of the lease and tenants do not have an equity position in the property (generally).  There are a few common exceptions and caveats to this exclusion that are generally accepted that we will not delve into here, but your tenant broker can walk you through in detail.
  • Depreciation and Amortization Charges for the Property and for Capital Equipment – In a typical scenario, if the landlord were to pass these items through to the tenant as an operating expense it would be an unreasonable profit center because the landlord should be depreciating these costs annually as a taxable expense, and these costs should already be covered by the rent collected by the landlord.
  • Corporate Overhead/Executive Salaries – This one can be tricky to properly define because of some of the grey areas that occur with landlords that are performing their own supervision and management of the property – which can be a huge and sometimes unreasonable profit center. The key is to focus on excluding expenses that are related to the operation of the landlord’s business or businesses, versus the operation of the building or project. Including language that limits management expenses is also advisable.
  • Advertising/Promotional expenses for the Project, Building or Premises – Much like the above exclusion, this is a cost a landlord incurs in attracting revenue, not the cost of operating a building.
  • Leasing Commissions and Related Expenses – This is the cost of doing business as a landlord and clearly should not be passed on to the tenant as an operating expense. Primarily, it should already be underwritten into the rent and would be double dipping.


In commercial leasing there are three basic types of operating cost lease structures:

  1. Industrial Triple Net (NNN)  Tenant is responsible for, and contracts directly with, vendors for any and all building services needed. Theoretically, the landlord should not have any building operating costs to pass through to the tenant; however, there are many Industrial Triple Net leases that occur in industrial parks with common areas that incur operating costs and must be maintained along with association fees. Therefore, even in industrial leases it is important to negotiate common area maintenance (“CAM”) and operating cost provisions carefully.
  2. Full Service Gross – In a true full service gross lease the landlord contracts with and pays directly all of the vendors for building services and includes those costs (pro rata share for each tenant) in the base rent that is collected from the tenants without any separate charge (e.g. operating cost escalations) to the tenant. Because the landlord is assuming all the risk of rising costs for the operation and maintenance of the building, true full service gross leases are a rarity.
  3. Modified Gross – Landlord passes “operating costs” through to the tenant for reimbursement of fees for which the landlord has contracted directly with, and paid vendors for, building services. Typically, a tenant is billed separately for its share of building operating costs in addition to base rent. There are several types of the modified gross lease: Base Year, Expense Stop, Stipulated Base Amount, and Office Triple Net.

Base Year Lease establishes a baseline of operating expenses for the tenant. The landlord and tenant agree that the total operating expenses in the “base year,” as defined by the lease, will establish the baseline value or contribution for which the landlord would be responsible. Typically, this is the first calendar year of the lease term but can be defined as another annual period. The tenant is responsible for the pro-rata share of operating expenses that exceed those expenses incurred in the base year in the subsequent comparison years. A tenant’s pro rata share is the rentable square feet of the tenant’s Premises divided by the rentable square feet of the Building/Project. Outside of the previously mentioned full service lease, this is generally the most tenant-friendly structure in office leasing.

Gross-Up” concept

Building operating expenses can fluctuate depending on levels of vacancy which change from time to time over a lease term, especially if a tenant is in a building with high vacancy. To protect the tenant from wild swings in operating expense costs, a gross-up provision allows the landlord to equitably project costs as if the building was consistently occupied [typically 95% to 100% occupied depending on the market]. This provides the tenant cost certainty and when variable expenses are grossed up during the tenant’s base year, it prevents the landlord from adding more variable operating expenses in subsequent years when the building is fully occupied. This concept is also applicable in expense stop, stipulated base amount, or an office NNN lease.

Expense Stop Leases establish for the tenant a fixed dollar amount that represents what the landlord is responsible for contributing to operating expenses. This dollar amount is expressed in terms of dollars per rentable square foot which serves as an offset against the actual building costs in a given year. The tenant is responsible for the pro rata share of any excess that occurs after subtracting the expense stop amount from the actual operating costs.

Stipulated Base Amount Leases are very similar to expense stop leases with the main difference being that the stipulated base amount is expressed as a whole dollar amount instead of a dollars-per-rentable square foot, making it not subject to issues that can arise from rounding.

Office Triple Net (NNN) Leases allow the landlord to contract and pay for building services (unlike industrial NNN), and then pass those costs through to the tenant for reimbursement without any expense offset to the tenant starting from lease commencement. Unfortunately for the tenant, this structure is becoming increasingly popular with office landlords across the market at large.

Cumulative vs Compound Caps

Real estate taxes, insurance, snow removal (where appropriate) and utilities are non-controllable expenses in an office building; everything else is controllable. Tenants with leverage should be negotiating on an annual cap to make sure controllable costs don’t get out of hand from year to year, holding the landlord accountable in managing their operating expenses.

There are inconsistencies industry wide as to how caps are applied and usually those inconsistencies are driven by incorrect language on leases which the landlord produces. No matter the type of cap, they can be distinguished by whether they are calculated over the prior year, or from the first year of the lease (base amount). Generally, there are two types of caps: cumulative and compound.

Cumulative caps always reference the initial base period when the additive value of the cap is multiplied. Here is an example of a cumulative cap calculation formula at 4% over 4 years:

Year 1:  Base Amount

Year 2:  Base Amount x [1+4%]

Year 3:  Base Amount x [1+(4%+4%)]

Year 4:  Base Amount x [1+(4%+4%+4%)]

Compound caps reference the previous year’s value when multiplied to calculate the next year’s cap (if it is calculated from the base amount, it must be stated explicitly in the lease). Here is an example of compound cap calculation (over the prior year) formulas at 4% over 4 years:

Year 1:  Base Amount

Year 2:  Base Amount x [1+4%]

Year 3:  “Lesser Of” x [1+4%]

Year 4:  “Lesser Of” x [1+4%]

(“Lesser Of” is the lower of the prior year’s actual expense or the expense cap amount)

The advantage of the compound cap when calculated over the previous year is that if and when expenses either don’t increase, or increase less than the cap, the tenant saves money.

No matter what type of cap is negotiated we highly recommend examples using hypothetical numbers are included in the lease language to mitigate any confusion or misinterpretation when referenced later.

These are the major structuring terms for operating expense calculations; they are vitally important as they set the formula for the tenant’s operating expenses during the entire term of the lease. Do not underestimate the level of difficulty to obtain optimal terms with certain landlords on the structure; a good tenant-only broker can help you achieve optimal results.

Understanding how operating expenses are defined and how they can be structured into a lease is vitally important, so now that you know that and have negotiated appropriate terms with your team – how do implement and enforce this aspect of your lease?


Audit Rights

Of what good is negotiating an awesome lease, with tenant-friendly operating expense language, if the tenant does not hold the landlord accountable to the lease language during the term of the lease?

Having the ability to audit the landlord’s books and records is extremely important. In our experience, out of 10 leases for which we do a preliminary review, 7 to 8 have billing issues and of those, 2 to 4 have enough issues to warrant auditing the landlord’s books and records.

I can’t underscore enough the importance of annual preliminary reviews to see if an audit is warranted, especially for larger tenants where realized savings from mistakes made by the landlord can be in the six- and even seven-figure range over the life of the lease – much more significant than that extra month of abated rent you might be overly focused on in a lease negotiation.

In conclusion, let’s do a quick review: excluding base rent and other explicitly financial landlord concessions to the tenant, operating expense structure, definitions, and implementation thereof financially impact the tenant more than virtually any other section of an office lease. If tenants don’t negotiate and exercise rights to conduct annual preliminary reviews to determine if a full audit is necessary, they are likely throwing money away and/or wasting the cost, time and energy of their team that negotiated optimal operating expense terms.

For more information on obtaining a no-cost preliminary review of your lease to determine if an audit is warranted, please contact Darius directly, or reach out to any of our CRE tenant rep experts.

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