A Short Discussion of Operating Expenses and Taxes (Insert Big Yawn Here)

I know.  This is painful. But you need to understand it, so here goes.  A third or more of a tenant’s occupancy cost is attributed to the operation and taxation of the building in which it leases space.  Yet these costs and how they are distributed are often a source of confusion. 

Firstly, there are several ways in which landlords deal with these expenses.  In San Francisco, for most class A buildings, the common approach is what is known as a full-service, gross lease with a Base Year. In this case, the Base Year is established during the negotiations, typically the year in which the new lease commences; provided, however, if the lease starts in the 2nd half of the year, the Base Year is often pushed to the following calendar year.  In simple terms, during the Base Year, the tenant pays only its Base Rent. So, for example, if the Base Rent is $70/sf, it only pays $70/sf.  The total amount of operating expenses and real estate taxes for the full calendar year, less any excluded items, is then established as the Base Year amount.  For example, if the operating expenses total $18/sf and the taxes are $5/sf, the total Base Year value is $23/sf.  The tenant then pays its pro rata share of any increases above these amounts as such increases may occur in subsequent lease years.  So if operating expenses go from $18/sf to $18.50/sf, the tenant is responsible for the $.50/sf increase.  If the tenant occupies 10,000 sf, that translates to $5,000 in additional operating expense costs for that lease year.  Similarly, if taxes increase, the value of the increase is passed on to the tenant.  Under this lease structure, the building management team will project future increases at the end of a given calendar year and in the next calendar year, charge the tenant the estimated monthly value of the projected increases.  At the end of that year, management will “true up” the costs and either bill the tenant for any shortfall or credit back any overage.

Another common approach to leasing is what’s known as a NNN lease.  In this lease structure, the tenant pays all operating expenses and taxes.  It pays a Base Rent, which is usually lower than the Base Rent you find in a gross lease since the tenant is picking up all the expenses and taxes.  So if the space in our prior example was leased as a NNN lease, it would likely have a Base Rent of $47/sf and a total year one NNN rent of $70/sf.  The operating expenses and taxes would be the same (e.g., $23/sf) but they would be passed on to the tenant in full from day one.  In subsequent years, the cost would increase based on the extent to which the lease calls for Base Rent increases and the extent to which the operating expenses and taxes increase.  NNN leases can end up being a little less costly than Gross Leases because the annual Base Rent increases are done from the Base Rent value, not the fully-serviced rent.  In the first example, where the starting rent is $70/sf if there is a 3% annual rent escalation, it is calculated off the $70/sf rate; whereas in the case of the NNN lease, the annual rent escalation is calculated off the $47/sf rate. 

There are numerous other variations of the concept.  For example, some leases are NOE, which stands for Net of Electricity.  And there are leases which are NUJ, or Industrial Gross, both of which are net of utilities and janitorial.

It’s no wonder this can be confusing.  Adding to the confusion is the negotiation around what should be included and excluded in the calculations.  A good real estate advisor will be well-versed in all the different ways in which expenses and taxes are treated and will be able to successfully negotiate appropriate exclusions.  This is but one of the seemingly obscure areas in which a tenant seeking to negotiate on its own is likely to miss the opportunity to mitigate costs.