Limiting Lease Costs
Tenant Representatives Can Help Find and Reduce Hidden Charges.
Commercial real estate professionals who are versed in the art of lease negotiation will find many consulting opportunities in the area of tenant representation. Tenants that represent themselves during lease negotiations with building owners or managers often end up paying more than they should in unknown costs. Hiring a lease negotiation representative can improve their position at the bargaining table.
Most tenant representatives already have a clear understanding of their local market's rents and costs, as well as the supply-and-demand factors of local property types. They also generally are well versed in the language of leases. Most brokers are part of a team of experts that includes accountants and attorneys who assist in lease negotiations and transactions. A new breed of lease-cost consultants is becoming more common as members of these negotiating teams.
Brokers acting as tenant representatives should concentrate on areas of the lease where landlords' costs are subject to negotiations. Generally, a dramatic void exists in the details of landlords' cost accounting that makes up a sizeable percentage of total rent. By paying attention to discretionary costs and employing the following lease-administration strategies, tenant representatives can lower costs over the life of the lease, leading to significant rent reductions.
Discretionary Costs In addition to the base rent, which usually is calculated on a per-square-foot basis, most tenants pay for building operating costs as well. Sometimes referred to as pass-throughs, these costs represent the share of a building's operating expenses that the landlord determines a tenant should pay. However, landlords can compile discretionary costs in an unlimited number of ways.
Tenant representatives should recognize that building operating costs are discretionary and generally are divided into two categories: semidiscretionary and totally discretionary. Maintenance labor is a good example of a semidiscretionary cost. Most commercial landlords have personnel on staff to handle various maintenance and repair functions. The cost of having these people in-house gets passed through to the tenants, and landlords can decide how they want to distribute the cost.
For example, say that one mechanic is responsible for two 100,000-sf buildings in a twin building complex. The mechanic's total salary is $50,000 per year including all fringe benefits and taxes. How should this cost be allocated among building tenants? Many people would say that each building should be responsible for $25,000.
But suppose the owner adds a 15 percent overhead fee and allocates costs based on occupancy rather than available area. Under these circumstances, if building A was 60 percent occupied and building B was 30 percent occupied, building A would be charged $38,333 ($50,000 x 1.15 x 60/90) and building B would be charged $19,167 ($50,000 x 1.15 x 30/90).
These calculations likely will not appear on any tenant reconciliation statement. In fact, there probably will be no line item for maintenance labor because the cost will be a part of miscellaneous maintenance or a similar category. But the result is that tenants in building A are being overcharged.
Totally discretionary costs may be more unwieldy because they are decided on solely by landlords. The best example is management fees. Many leases allow landlords to recover a fee as a cost of providing management services to a building but do not limit or define this cost. Including a clause that defines how this cost is to be determined is a simple strategy that can save tenants money.
While slight differences exist among various property types in how these costs are to be recovered, the issues related to discretionary costs are universal. In spite of language requiring generally accepted accounting principles, landlords essentially are on their own to compile these costs in almost any way they choose. Most leases generated by landlords give them wide latitude in this area. The objective of a tenant representative is to take that latitude away and determine precisely what the tenant will pay for, how the cost is to be determined, and what costs will be excluded.
Cost-Cutting Strategies Along with monitoring discretionary costs, tenant representatives can rely on the following strategies to further reduce tenant costs.
Help tenants to establish a formal process as leases come up for renewal. This process should include a written outline of the tenant's objectives, budget, personnel requirements, location, and other concerns. It also should include a timetable that allows for substantial slippage as the process unfolds.
When choosing a new space, corporate real estate managers should establish time lines so that the space selection process can unfold in a reasonable manner. The norm for many companies is to delay decisions, resulting in shortened selection and negotiation periods. Landlords understand this and sometimes will delay the process further, often to their advantage.
Software now is available to help companies project growth, which can result in smarter decisions regarding the length of the lease and size of the space. Additionally, these programs allow senior management to more properly measure the impact of real estate costs on a portfolio basis.
Tenant representatives must tell their clients to stay in the background during negotiations. Tenants that participate in negotiations directly or want to develop a personal rapport with the landlord can cost their organizations money. The tenant and prospective building landlord should not have direct discussions prior to signing the lease, because it may weaken a tenant's bargaining position. Ideally, a tenant representative should deal with only one corporate real estate professional who has the authority to decide where a deal will be made.
Analyzing Other Deals.
Once the finalists in any space competition are selected, most tenants typically start comparing the economics and subjective factors of the locations. The level of sophistication of this process varies widely. In the financial area, considering just lease costs may be too narrow. Ideally, personnel; furniture, fixtures, and equipment; communications; data; relocation; and other costs also should be considered to compute the true bottom line to the company.
Analyses for net present value, average rent, and other per-person investigations also can be informative. These particularly are helpful if comparisons can be made on a portfolio basis instead of on deal alternatives only. State-of-the-art lease-management software can make this analysis relatively easy.
On the qualitative level, various systems are available, but in most cases, a simple ranked-sensitivity table may be as good as more sophisticated methods (see chart). By knowing what is important to the tenant, representatives properly can analyze alternative proposals on a broad basis of several factors.
It is not uncommon for tenants to assume that the rentable sf in one building is the same as the rentable sf in another building. But often that is not the case.
Every lease should include a standard description of how space is to be measured, so that, for example, interior planners or architects can use the description to calculate the same number of rentable sf as the landlord.
In office space, the most reliable, consistent standard is from the Building Owners and Managers Association. BOMA produces a standard for the measurement of office buildings sanctioned by the American National Standards Institute. The current version allows building owners to achieve an additional 2 percent to 4 percent larger rentable area for the same usable area.
A 100-sf variance for a $25-per-rentable-sf lease is worth $2,500. Over five years, this is $10,000-plus in pass-throughs. Using the same assumptions for a 100-lease portfolio, a measurement error of only 100 sf per lease is worth $250,000.
In most new office leases, the landlord offers some form of tenant improvements as part of the deal. In a new building, the landlord may offer a work letter that includes quantities of various standard components on a unit-cost basis. Landlords typically value this work letter at some dollar figure psf.
However, tenants rarely build exactly as the work letter specifies, instead using higher or lower quantities and finish levels. Tenants need the unit costs on a line-by-line basis so that total costs can be determined once the build-out plan has been prepared.
When comparing buildings, tenant representatives should get unit costs for all typical build-out items, making sure they understand how the construction costs will be compiled and what amounts are established for general conditions, overhead, and profit for each deal.
Another tactic is to hire a qualified professional to represent the tenant as a construction manager to negotiate this portion of the lease contract. Consulting fees may be inexpensive compared with the big dollars that may be hidden in the construction allowance that only a professional will see.
Expense vs. Capital Cost.
Most pass-through clauses allow for the recovery of normal operating expenses. Office and industrial leases generally exclude capital expenses as a recovery item. Retail leases vary significantly over capital cost recovery. Unfortunately, the rules for classifying many significant costs as capital or expense generally are gray.
When a professional examination of pass-through costs is undertaken, some costs usually are characterized as capital rather than as expense. In older buildings, particularly those that are undergoing renovation, the incidence of mischaracterization increases.
The classic example of the expense/capital question is the resurfacing of a shopping center parking lot. If the landlord resurfaces the entire lot for $1 million, the cost clearly is a capital expense. However, what if the landlord repairs 10 percent of the lot each year for 10 years? Many shopping center landlords have been doing this for years and passing through the “repair” cost every year as an operating expense.
In office buildings, if an owner classifies an item as expense, the tenant pays for it. If it is classified as capital, the cost comes out of the building's profit. So there is a predisposition to expense whatever possibly can be considered in that category. Insisting on GAAP as the benchmark for classification as a capital cost will improve the tenant's position somewhat, although GAAP alone will not provide sufficient tenant protection.
The smart tenant will identify the threshold of materiality as a specific dollar amount (say $10,000) in the lease. If a cost exceeds that amount, it is subject to scrutiny to be classified as capital if it meets the other capital tests (a useful life of more than three years, extending the life or improving the service of the asset, and classification as nonrecurring in nature).
Actual vs. Adjusted Costs.
Most office and some retail leases allow for the adjustment of actual costs to reflect what they would be if the project was fully occupied. Commonly known as the “gross-up” provision, it is a fair and appropriate provision to adjust costs.
While the gross-up provision is a frequently employed concept, most office leases never describe properly how costs should be adjusted. This ambiguity leads many landlords to adjust costs improperly to include not only those that vary with occupancy, but those that don't. Thus, many gross-up implementations overstate adjusted costs significantly. Similarly, many landlords allocate costs based on whatever method generates the greatest cost recovery vs. what is fair to the tenants.
Ownership vs. Operating Costs.
Every description of operating expenses describes what costs are included as costs of operation. Correctly stated, operating expenses to be passed through to the tenants represent the costs of “maintenance, operation, and repair” of various building components. Sometimes additional words are included such as “replacement, refurbishment, ownership, leasing” and other qualifiers. These additional phrases describe costs of ownership, not operation. These costs should be absorbed by the landlord as part of its overhead or be considered capital in nature and beyond the tenant's obligation.
One landlord used a lease that included “all costs of whatsoever nature associated with the operation, repair, maintenance, and leasing of the building” as its definition of what qualified as a pass-through cost. It proceeded to pass through these leasing costs as a line item. When questioned about what they were, the landlord stated that they were the costs of leasing commissions and tenant improvements to put new tenants in the building, which certainly were costs of leasing but were not appropriate for pass-through.
Many landlords include management fees and, in the case of retail leases, also add administrative fees. But in many cases there is no third-party payment, so without a limitation, the landlord is free to put whatever it wants into these fees.
A simple, effective tool to keep costs down is the use of caps on selected costs, especially these fees. Once again, state-of-the-art lease-management software dramatically enhances negotiated caps and allows them to come alive in a portfolio.
Audit Rights and Performance.
The rate of lease compliance audits in commercial leases still is less than 5 percent on a portfolio basis. This means that 95 percent of building billings are presented and paid without the simplest testing of the appropriateness of the charges.
Selective lease compliance auditing is the only effective way to monitor the charges. This process should be performed in conjunction with an overall commitment to cost control and sensitivity to transaction and organizational objectives regarding each lease.
Lease Transaction Reviews A lease transaction review performed by a competent lease-consulting firm provides another set of eyes — those trained to weed out unnecessary expenses at the time of the lease negotiation. A well-done LTR eliminates a lease's gray areas, clearly determines how various costs are to be computed and billed, lists what costs are to be excluded, and most importantly, defines how costs are to be reviewed by the tenant.
Most LTRs are simple markups of a lease with suggested changes and clarifications. They can be performed in a few hours and cost less than $500. Look for professionals that have significant experience in real estate accounting and leasing and have performed numerous lease compliance audits. The return on this investment will be a hundredfold or more in a properly administered lease portfolio.
LTRs make it easy for tenants later to review costs and, perhaps more importantly, prescribe a manner to reconcile any disputes quickly and without significant cost.