1. Understanding OFFICE LEASE Operating Expenses
Presented by: Susan Rebelo, Fresenius Medical Care
Teresa Fettig, The Talbots, Inc.

2. Operating expenses defined How does your lease define them?
Operating Expenses are generally defined as the costs associated with the management, operation and maintenance of a commercial property.
How does your lease define them?

3. Broad or limited definition
Landlords prefer a broad operating expense definition to allow for the inclusion of ownership costs, capital improvements, legal expense, and warranties to name a few.
Tenants will seek to exclude these expenses and more such as costs covered by landlords’ insurance, debt financing, and costs to other tenant’s spaces among other charges.

4. Line Item Breakdown Repair & Maintenance $ 550,000 $ 1.50/sf
Cleaning/Janitorial $ 350,000 $ 1.00/sf
Repair & Maintenance $ 550,000 $ 1.50/sf
Landscaping $ ,000 $ 0.25/sf
Life Safety & Security $ 150,000 $ 0.40/sf
Management Fees $ 300,000 $ 0.80/sf
Administrative $ 250,000 $ 0.65/sf
Utilities $ 600,000 $ 1.25/sf
Taxes $1,207,000 $ 3.45/sf
Insurance $ 167,000 $ 0.50/sf
Parking $ 125,000 $ 0.40/sf
Capital $ 100,000 $ 0.30/sf
Cafeteria $ ,000 $ 0.20/sf
Fitness Center $ , $ 0.05/sf
Total Operating Expenses $3,954,000 $10.75/sf

5. Breakdown of costs Total Payment = $22.00 psf
Speaking Points: Operating Expenses are a component of total annual rents as depicted in this slide. Although real estate taxes and premise electricity are considered operating expenses, it is common for these expenses to be broken out when determining overall costs.
Total Payment = $22.00 psf
(Opex + RET + Ins = $10.75 psf)

6. These Key Factors define how you view Operating Expenses!
TYPE OF VENUE
TYPE OF LEASE
These Key Factors define how you view Operating Expenses!

7. Venue type Office Towers Industrial Mixed Use Developments
Office Campus

8. Types of Leases Net Modified Gross Gross (Full Service) Base Year
Expense Stop
Gross (Full Service)

9. Types of Leases - net
Expenses are paid in full by Tenant either directly to vendor or service provider, or as a share of pass-through expenses – Expenses may be audited
Variations include Net-Net or Triple Net leases
$10.00/sf Base Rent payment to landlord
$ 6.80/sf Operating Expenses
$ /sf Insurance
$ 3.45/sf Real Estate Taxes
$ 1.25/sf Tenant Electricity
$22.00/sf TOTAL ANNUAL PAYMENT
Differentiating factor being whether the landlord or tenant is responsible for the performance of the particular service.

10. Types of Leases – Gross (full service)
Tenant occupies its building with no physical operational or management responsibilities other than paying the rent once a month.
Monthly rent covers ALL expenses, with no adjustment should any of the costs increase or decrease - Expenses are not subject to audit
$22.00/sf “Gross Rent” payment to the landlord
These types of leases are typically found in small office venues such as executive suites, government leases and in many sublease settings. The lump sum payment of $18.75/sf reimburses the LL for all expenses regardless of actual cost.

11. cost COMPARISON net vs Gross
Total Payment = $22.00 psf - GROSS

12. Types of leases – modified gross
Tenant occupies its premises with little to no operational management responsibilities for the property.
Tenant may choose to pay directly for certain services while other building services are paid for and provided by the landlord then allocated as a pass-through expense and may be audited.
Single-tenant occupied property may assume additional services (utilities, trash removal, etc. or direct payment of real estate taxes).
There are many variations of modified gross leases. Bullet points. When a tenant assumes the responsibility to maintain and pay for any service the operating cost component of the gross base rent is decreased accordingly.

13. Types of leases – base year
$22.00/sf Annual Base Rent (contains $6.80/sf = estimated operating expense base year value)
Subsequent year’s costs are compared to the base year value.
$ 6.95/sf Actual Operating Expense Year 2
$ 6.80/sf Actual Operating Expense Year 1 (BY Value)
$ 0.15/sf Billed to Tenant
The difference should only reflect inflationary or extraordinary increases over the base year value allowing for an apples-to-apples comparison of costs.
A base year lease is a common form of a modified gross lease. As with a gross lease, the annual base rent of $18.75/sf is made up of a negotiated value for operating expense, taxes, electricity, etc. In this example, the negotiated operating expenses is $5/sf representing a form of pre-payment toward the annual incurred operating expense. The actual first year costs came in at $5.10/sf so the negotiated value wasn’t too off the mark. Actual cost below or above the negotiated value of the gross rent component puts risk on either the tenant or the landlord. Auditing base year values is highly recommended and yields future cost savings. Reduction to gross rent value does not occur if actual costs are below negotiated component.

14. Types of leases – expense stop
Conceptually similar to Base Year lease structure
Expense Stop value is a stated amount instead of actual operating cost, meaning it is not adjustable.
$ 7.00/sf Actual Operating Expense Year 2
$ 6.80/sf Stated Operating Expense Stop
$ 0.20/sf Billed to Tenant
Increased risk to both tenant and landlord.
Modified Gross lease form currently not as common as a base year lease. Presumed to pre-date base year leases, modified further to allow for adjustment to the base year value.

16. Gross Up Adjustment Extrapolation
An artificial increase to those categories of operating expenses affected by changes in occupancy (variable costs) to reflect what such costs would have been if a building/property was fully occupied during the year.
Fundamental to the fair application of modified gross lease method.
When done correctly, both parties benefit from this process.
Exercise ensures the landlord is fairly reimbursed by the tenants who are occupying the property.

17. GROSS UP ADJUSTMENT - VARIABLE VS FIXED COSTS
Electricity
Water
Cleaning
Security
Rubbish Removal
Management Fees
Taxes
Insurance
Repairs & Maintenance
On-site Management
Cafeteria/Fitness
*****VARIABLE? FIXED? OR BOTH?*****

18. Gross up adjustment – how it’s done
Gross up factor can be any percentage – most commonly 95% or 100%
Divide year-end variable costs by the property’s weighted average occupancy percentage then multiply by the gross up factor.
$50,000/.734 x 95%
Most line item breakdowns do not distinguish between fixed and variable costs, and they may not show costs before and after gross up adjustments so this exercise is most commonly performed during an audit.

19. Gross up adjustment-how it works
Building Size = 100,000 sf
Premises Cleaning Expense = $1.00/sf
Building’s Average Annual Occupancy = 75%
Company ABC Premises/Pro Rata Share = 50,000sf/50%
Actual Incurred Cleaning Costs = $75,000
Cost to Clean ABC’s Premises = $50,000
ABC’s Pro Rata Share Without Gross Up = $75,000 x 50% = $37,500 vs $50,000
Annual Cleaning Costs Grossed Up to Full Occupancy = $100,000
Tenant’s Share With Gross Up = $100,000 x 50% = $50,000
When you have the ability to audit and have access to contracts you are able to obtain the cleaning cost psf and perform this exercise.

20. Gross up adjustment – why it works

21. pizza

22. What to watch out for!! Expense Exclusions
Legal Description, Site Plan and other key elements clearly defined
Scope of Services (i.e. Cleaning Specs.)
Gross-up language included in base year leases
Gross-up calculations-variable vs. fixed
GAAP
Audit Rights
Recap pros/cons of lease types, etc.

23. Operating expense allocations

24. Cleaning/janitorial Nightly Cleaning Day Porter
Miscellaneous (carpet cleaning, etc.)
Janitorial Supplies
Window Cleaning
Trash & Hauling

25. Repairs & Maintenance Elevator Asphalt/Paving/Sidewalk Repairs HVAC
Engineering/Maintenance Technician
Pest Control
Uniforms
Lighting/Electrical
Geese Patrols
Asphalt/Paving/Sidewalk Repairs
Painting & Decorating
Roof Repairs
Int./Ext. Building
Vehicle
Plumbing
Bulb replacement
Metal/Marble

26. Landscaping Interior Plant Maintenance Exterior Landscape
Snow and Ice Removal
Parking Lot Sweeping

27. Life Safety & Security Fire Alarm System/Sprinkler System
Fire Equipment Fees
Security Contract
Security Access Control System
Security Miscellaneous

28. Management Fees
Overall management of the property is performed either directly by the landlord or via a third party management firm.
Day-to-day management involves:
Rental Collection
Administration
Tenant Relation Activities
Service Contract Management
Lease Negotiations
Management Fees are a customary inclusion in office lease settings unlike retail settings.

29. Management Fees How Determined? Fixed Fee-Newer projects
Cost Basis-Retail Projects (as a % of incurred expense)
Revenue Basis-Office Projects (as a % of gross income)
What is Market? Office project markets are generally 3-5% of the property’s gross income
Fees collected do not cover any of the property management salaries or expenses, but are instead viewed as an incentive payment to successfully manage the property.

30. capital GAAP Standard vs. Reasonableness Test
Repair/upgrade vs. Replacement
Useful Life vs. Payback Period
Government Mandated and Cost Reducing vs. All Capital

31. Administrative expenses
Employee Development
Dues/Subscriptions
Printing
Postage
Events/Gifts
Professional Fees/Consultants
Charitable Contributions
Travel
Management Office Rent
Office Supplies
Salaries/Payroll
Bank Fees
Permit Fees
Telephone
Office Furniture and Equipment
Grounds Transportation (Shuttle)

32. Utilities Electricity – kwh/load factors Gas (interior)
Water (irrigation or premises)
Sewer (benefits interior)
Fuel (equipment)

33. Taxes and insurance Taxes Insurance Ad Valorem Taxes
Non Ad Valorem Taxes
Special Assessments
Personal Property
Sales Tax
Income/Margin
General Liability
Property Coverage
Business Income
Auto
Workers Comp
Wind
Buy Back Deductible
Pollution
In Base Year leases it is important to include language to ensure the base year value represents fully assessed properties.

34. Parking Direct Costs Indirect costs Attendant Labor Benefits
Incidentals
Ticket Printing
Striping
Garage Sweeping
Liability Insurance
Operator Mgmt. Fee
Real Estate Taxes
Building Insurance
Utilities
Elevators
Maintenance
Property Mgr. Salaries
Owner Mgmt. Fees on Parking Revenues

35. Cafeteria/fitness Center subsidy
The cost to operate a fitness center or cafeteria may be subsidized by the Landlord and included as a pass-through expense.
These facilities usually do not turn a profit so the inclusion of the subsidy allows the Landlord to provide the amenity

36. Project Cafeteria Statement of Operations
Revenue:
Salaries
$ ,528
Sales
$ ,461
Payroll Taxes & Benefits
$ ,109
Special Functions
$ ,821
Total Payroll Costs
$ ,637
Conference Room Sales $
Total Sales
$ ,282
Operating Costs:
Paper & Plastics
$ ,787
Costs of Goods Sold:
Cleaning Supplies
$ ,472
Food
$ ,286
Laundry & Uniforms
$ ,710
Sundry
Accounting & Auditing Fees
$ ,800
Total Costs of Goods Sold
Other Expenses $
Total Operating Expenses
$ ,048
Gross Profit
$ ,996
Total Expenses
$ ,685
Net Profit (Loss)
$ (145,689)
Average Daily Lunch Participation
143

38. What to watch out for!!
Tenants requiring additional or specialized services
Construction or build-out costs
Fixed and Variable Expenses Grossed-Up
Property Allocation Process

39. What to watch out for!! Large fluctuations in year-to-year expenses
Base Year contains full year’s worth of expense
Property manager acting as asset manager
Tax Refunds not passed through to tenants
Assessed value in base years
PILOT programs

40. What to watch out for!!
Blanket Insurance policies including high risk properties
Insurance Deductibles
LL collecting rent for monthly parking AND passing through parking operating costs.
Ownership changes

41. Understanding OFFICE LEASE Operating Expenses
Questions?

42. Contact Information
Teresa Fettig The Talbots, Inc. Sue Rebelo Fresenius Medical Care