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?
WHAT IS YOUR RENT TO REVENUE RATIO?
One financial metric that many business owners are unfamiliar with is the industry rent-to-revenue ratio (I-RRR). The math is simple; rent paid divided by total revenue from operations. Naturally, some industries will pay a higher percentage of their revenue in rent; a retail shop will surely pay a different percentage of revenue to rent compared to a small law firm.
So what is your I-RRR? With data collected across the entire nation, manufacturers, on average, paid 1.78% of their total revenue from operations toward rent. In 2017, they paid 1.87%; 2018 they paid 1.77%; and in 2019, they paid 1.69%
The amount of rent a business must pay involves many factors. Location, site access, building quality, and, most importantly, market conditions are all factors. A business in New York City will certainly pay more in rent while a business in rural Minnesota may pay less. The formula is simple, but the underlying factors can be quite complicated. Many companies believe their I-RRR should be much lower during this economic slowdown. However, the dramatic drop in rents that occurred in 2008-2009 has not happened…yet. It is possible that large-scale business closures create urgency on behalf of landlords to make low cost deals, but it is not happening now. Stay tuned for more market information as we near the end of 2021.
Source of Data: Bizminer.com
Q & A
Questions Tenants often Ask Regarding Their Occupancy
Written by Bob Johnston | Vice President Sales & Leasing
QUESTION #1: What if the Landlord isn’t 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 tie 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, the lease might define a specific commencement date. 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, smaller tenants with smaller budgets, the only requirement is a formal letter requesting Landlord reimbursement of the allowance and proof of completion accompanied by all subcontractor lien waivers. Larger jobs can have a title company involved to administer “construction draws” and monitor 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, but each situation is different. The buildings architect can pre-measure individual spaces or bays. From the measurements, floor plans can be drawn. 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
Successful commercial leasing is all about understanding your rent. Most commercial leasing 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. Also, it is critical that the tenant understand what expenses make up operating costs. Then understand 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. Mixed use is 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. I 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.