When I was a young broker in the late 1980’s, I attended a dinner where a number of real estate developers spoke. When asked about operating expenses, one of the speakers, who was a New York City landlord, answered that any property manager who doesn’t make a ten percent profit on operating expenses he charged to his tenants is not doing a good job.
Famed hotel owner and convicted felon Leona Helmsley once charged the repainting of her home to one of her buildings, burying it in the commercial operating expenses of a building she owned. In actuality, the tenants of the building paid for the cost of her repainting.
In a similar vein, I once learned of a property owner who would purchase art for a building he owned. After a year or two, he would replace the art with new pieces and display the old pieces in his home. Once again, the tenants paid for the owner’s collection.
Operating expense pass throughs, commonly referred to as OPEX, can be a useful tool to help cover landlord expenses in financing the maintenance and operation of a commercial property. But there can be some challenges associated with a pass through in a lease – hence the title of this article.
Under the terms of a pass through in a lease, whether it be for the primary lease holder or someone subletting a commercial property, the property owner has the right to pass along to the tenants of a building the commercial real estate operating expenses, or the cost of the various components of operating the building. Each tenant pays its proportionate share of expenses based on the space they occupy in a building in a multi-tenanted building, or all the expenses if a tenant is the only one in a building. The landlord is able to charge, under the commercial lease, operating expenses such as real estate taxes, property insurance, electricity, snow removal, landscaping, and a number of other items that are outlined in the lease agreement between the parties.
On a gross lease, where the OPEX is included in the base rent, a tenant typically pays increased expenses over a base year, usually the year the tenant moved into the building. However, this can become a negotiating point while discussing a pass through in a lease. You may also be able to negotiate the date on which that base year begins.
What OPEX should you pay attention to where there is a pass through in a lease?
Here are some other items to get clarity on when negotiating a lease with a pass through:
- If a mechanical service to the premises needs to be repaired or replaced, is the tenant responsible for the cost? Does that change depending on where the tenant is in their lease, i.e., have only a few months remaining?
- Are capital improvements, such as a new roof, repaving a parking lot, or items of that nature being charged to tenants as an ordinary expense or as a capital expense, which should be charged to the tenant over the useful life of a repair or replacement according to Generally Accepted Accounting Principles?
As you can see, a pass through in a lease is a nuanced area of real estate transaction that leaves you vulnerable to problems. It is essential for you to speak with a qualified commercial real estate broker to guide you through the labyrinth. At McBride Corporate Real Estate, we have been working with tenants and the issues they face in negotiating commercial leases since 1959 with most of our brokers having at least twenty years of experience in commercial real estate. If we can help you, please contact us or give me a call at (201) 848-6107.