WHY OPERATING EXPENSES VARY FROM PROPERTY TO PROPERTY?
Have you ever wondered why operating expenses vary from property to property? Energy consumption, service levels and service contracts can vary greatly so it is advisable to secure the details prior to lease execution.
Expenses May Vary
Paramount has been involved in several recent office lease transactions. Many, highlight the need for a close review of the property’s operating budget. Some “full service” leases may include daily cleaning, vacuuming, replacing light bulbs and cleaning your breakroom. And then others may not include these services at all or the services may be on a more limited basis.
Most property owners reserve the right to change rules and regulations and janitorial specs. It’s a good practice for your representative to take the time to request the budget and janitorial specifications. Once you have the detailed information you will be better able to compare properties. After settling on your most desirable property, a close review of the associated lease language is advisable. Although, this may uncover conflicts or missing details that might surprise you during your term. As an example, say your employees prefer to eat lunch in your office suite. As a result, this practice most likely makes it imperative that janitorial specifications would include daily trash service. No one wants to smell that reheated salmon the first time let alone the rest of the week!
Knowing the service level upfront will allow you the opportunity to verify the details are incorporated into the final lease. After all, operating expenses and real estate taxes can be 50% or more of your overall rent and you should only be paying for services you receive.
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Office Agents: Nancy Powell, Vice President | Jeffrey Swanson, Associate
Industrial Agents: Fred Hedberg, CCIM, SIOR, Principal | Phil Simonet, Principal | John Young, CCIM, Vice President | Joseph Schultz, Associate | Jack Buttenhoff, Associate
WHY OPERATING EXPENSES VARY FROM PROPERTY TO PROPERTY?
INVENTORY STORAGE? Proceed with caution.
Since 2017, days of inventory have increased for manufacturing firms nationwide, which means inventory storage has also increased. Days of Inventory in 2019 hit 59, up from 53 in 2018, and 51 in 2017. Mathematically, a decrease in the cost of sales could be causing this. COGS have actually increased slightly from 75.80% of revenue in 2017 to 75.98% in 2019. This indicates that firms have an increasing amount of inventory. Assuming this is not an over-production issue, firms are not selling as much as years prior.
This could be interpreted as a sign of economic slowdown, even before the Covid-19 storm made landfall. The increase in inventory may lead some businesses to think that they need additional space, which they may have a legitimate need for, but if the underlying reason is because of a weaker economic environment, the right course of action for the business to take might not be committing to a new long-term lease. Companies that absolutely need to move product offsite may want to explore third-party warehousing as an option. It is not as cost-effective as leasing traditional warehouse space on a per square foot basis, but allows the end-user the flexibility to change on a month-to-month time horizon.
The global health crisis has further complicated the situation. Some manufacturers now cannot keep enough stock to satisfy their customer’s needs. This may temporarily reduce the need for additional storage, even though it would be financially feasible. As with most circumstances, each should be evaluated on a case-by-case basis.
Written by: Joseph Schultz, East Team Associate
Q & A
Commercial Real Estate Questions Tenants often Ask Regarding Their Occupancy
Written by Bob Johnston | Vice President Sales & Leasing
QUESTION #1: What if the Landlord is not finished building out my space by the time I want to move in?
ANSWER: If the Landlord is actually responsible for the completed work, much depends on how the lease is written and the commencement date defined. For example, a commencement date can be tied to the substantial completion of the space, so the lease will not commence until the Landlord completes the work. Sometimes, the date is even contingent upon occupancy and the commencement of business in the space. On the other hand, there might be a specific commencement date defined. If the Landlord is late, the lease language will generally state that there is no culpability on the Landlord’s part, but the commencement date becomes the date on which the space is completed and the initial term extended from that date. In short, these issues are negotiable and dependent on each tenant’s situation.
QUESTION #2: Toward the end of each calendar year, the Landlord sends us a note informing us of the new Common Area Maintenance (CAM) & Real Estate Tax estimate for the following year. However, we never get a breakdown of the actual expenses. Is that available?
ANSWER: Most landlords will provide that information if requested. It always helps to have language in the lease that allows for a tenant’s review of the costs; and with larger tenants, audit rights are always helpful.
QUESTION #3: What do I need to do to get the tenant improvement allowance provided by the Landlord?
ANSWER: Typically, for smaller tenants with smaller budgets, all that is required is a formal letter requesting Landlord reimbursement of the allowance and proof of completion accompanied by all subcontractor lien waivers. For larger jobs, sometimes a title company gets involved and administers “construction draws” and monitors the construction progress.
QUESTION #4: Do I need to hire a disinterested third party architect to confirm the size of my space?
ANSWER: Typically not. This can be warranted in certain circumstances. Individual spaces/bays are already pre-measured by the building’s architect and floor plans are drawn based on those measurements. Therefore, the space computation is generally accurate. RU factors can vary by building, and are often much higher in smaller buildings. It helps to check the accuracy of the actual useable space and clarify the respective RU factor to calculate the rentable area (the number that determines the annual rent).
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Successful Commercial Leasing=Understanding Your Rent
by Bob Johnston | Vice President Sales & Leasing
THE TERMINOLOGY OF RENT
Most commercial leases today are “net leases”, meaning that the tenant pays a “base rent” which is “net rent”, or separate from, the operating costs and real estate taxes for the property. The operating costs are then passed on to the tenant as a separate cost, equaling a total rent cost and what many then refer to as “gross rent.”
Even this varies, however, from property to property. For example, often times in retail and industrial properties, tenants pay for their use of electricity and gas as well as janitorial services. In addition, sometimes the tenant, at its expense, must contract for local trash pick-up. These separately contracted costs are not part of the ordinary operating expenses. On the other hand, office leases typically are “full service” leases. In other words, there are generally no extra charges, other than perhaps charges for extraordinary use of services such as air conditioning or cleaning, etc.
It is critical that a tenant understand the complete picture and know what the total rent will be. In addition, it is also critical that the tenant understand what expenses make up operating costs and what costs are reasonable and legitimate. It is obviously to the landlord’s advantage to get the tenant to pay as much of the total operating budget as possible. This is even more critical in mixed-use projects where landlords tend to shift maintenance costs for the residences to the office component. Thus, the office tenant contribution is actually more than what it should be. I once audited the landlord of a very large mixed-use project in Chicago and found over $100,000 wrongfully allocated to the tenant even though the lease prohibited their doing so.
WHAT SHOULD NOT BE INCLUDED IN RENT?
Here are some suggestions as to what to eliminate from the landlord’s menu. The list is obviously not exhaustive, but rather illustrative of some of the costs landlords attempt to pass on to tenants:
Leasing commissions, space planning expenses with architects/interior designers, or even attorney costs associated with a lease negotiation or existing tenant dispute
Costs associated with the construction of tenant improvements, either with new tenant relocations or existing tenant renovations and remodeling
Costs associated with the entity of landlord, particularly as it relates to partnership/ownership issues or the selling or refinancing the property
Many large landlords have affiliates or interests in affiliate companies, so it is important to ensure that the contracted vendor costs are no more than what an unrelated third party vendor might charge
Be careful about the expenses for salaries, benefits, etc. that go into “management fees.” Executive salaries, or any allocation of those salaries, should not be part of the operating costs for the building
Capital improvements are not, by accounting standards, expense items, although landlords can routinely pass on the amortized cost of the improvement as an operating expense
Make certain that in a retail environment, the tenant’s pro-rata share of operating expenses is calculated over the entire leasable area of the property rather than only on the space currently leased and occupied.
Proper due diligence and understanding of the components of a building’s operating budget are critical to a tenant’s successful occupancy, financial stability and long-term enjoyment of the space.