Industry jargon. Commercial real estate is chock-full of it. Whether you have negotiated a commercial lease before or it’s your first time, chances are you will run into some potentially... Read More
The “base year” is generally the first year of a commercial rental period that sets a precedent for how much tenants will pay for building expenses for each subsequent year. Depending on the type of lease, during the first year, tenants either pay only for the base rent, or they pay for the base rent plus a projected building operation cost based on their percentage of occupancy. At the end of the first year, the landlord calculates the actual per square foot operating costs for the building. Let’s say the operating costs were $9/square foot. That’s what you’re going to have to pay for operating costs in every subsequent year, in addition to a pro-rata (proportionate) share of the building’s operating expenses that go beyond $9/square foot. The percentage of the building a tenant occupies usually determines their pro-rata share of expenses. If you occupy 10% of the building, for example, your pro-rata share of operating expenses is 10%.
Base year is crucial to any lease negotiation, and it’s important to review with your broker, and lawyer to ensure financial success. Since the base year is designed to favor landlords and protect them from excessive annual increases in operating expenses, when overlooked, it can cause considerable harm to a tenant’s bottom line. However, a prepared and educated tenant can protect themselves against unexpected increases in their pro-rata shares.
Here’s what you should know about base year, and how to move forward.
Lease types and the base year
The definition of base year might seem simple, but the base year rate is calculated in different ways depending on what kind of lease you are signing. In a full-service or modified gross lease, tenants pay only base rent for the first year of the occupancy period, while the landlord pays for all the building’s operating expenses. In a full-service gross lease, the landlord pays for tax, insurance, utilities, in-suite janitorial, and Common Area Maintenance (CAM). Modified gross leases typically require tenants to pay for utilities, in-suite janitorial, and CAM.
For the first year, both of these lease types look pretty much the same. But because of the base year clause often found in modified gross leases, most tenants become responsible for paying a pro-rata (proportionate) share of the building’s operating expenses beginning the second year.
Base Year and Pro-Rata Share
In a modified gross or full-service lease, the landlord has you covered and will pay the operating expenses incurred for the first calendar year—or base year—of the lease. Then, your business starts paying its pro-rata share the next year. It seems like the price would be relatively straightforward to measure, right? Here’s where it gets interesting.
Whatever operating expenses were incurred during that first year becomes the annual cap on the landlord’s contribution to operating expenses going forward. Imagine that your business occupies 10% of a property. If during the second year, the building incurs an operating expense increase of $100,000, you have to pay your pro-rata share of $100,000. Because you rent 10% of the property, you now owe $10,000.
Those calculations might sound simple enough, but the upfront simplicity is all the more reason to pay extra attention to base year when signing a new lease. You should be aware of at least a couple of scenarios in which, suddenly, your operating expenses could start to spiral out of control.
Scenario One: Deferred Expenses
Some landlords have no qualms about manipulating base year operating expenses to get more dollars from you later. For example, a landlord may delay making building repairs until your base year comes to an end.
Here’s how it can work. Remember those common area maintenance expenses from earlier? These expenses, such as elevator maintenance or water utilities, directly benefit all of the tenants of a property and as such, after the base year, each tenant becomes partially responsible for those costs. For example, a landlord might decide to delay installing that new HVAC system until you’re a year out from your base year. In that case, you might notice a significant increase in operating expenses from the base year that, this time around, you’re partially responsible for.
If your landlord included an annual rent increase in your lease terms, the longer CAM expenses are deferred, the more considerable increase you’ll see from your base year expenses and the less likely you’ll be prepared to cover your share of the cost.
So, what can you do to prepare for deferred expenses?
Solution: Look at the Data
Thanks to inflation, office rental prices in many U.S. markets can be expected to go up by 3% each year. Ask your landlord for operating expense data from the previous two or three years of rental history and look at the trends. Using that as a reference, set aside an estimated 2-3% of your current year’s operating expenses to prepare for the following year’s potential hike in operating expenses.
It’s also in your best interest to negotiate a lease that grants you the right to request an audit of the landlord’s operating expenses records. Careful research and accounting now will save you a lot of trouble later.
Scenario Two: Variable Expenses
Tenants also need to pay attention to rising variable expenses, which typically go up when more tenants move into the building. Examples of variable expenses include utilities, trash removal, management fees, and janitor services.
Remember, your pro-rata share of operating expenses is determined by the percentage of the building you occupy. And you’re only responsible for that after the base year.
You see where this is going.
What happens when you move into a half-occupied building that, over the duration of your lease term, fills up with more tenants who start driving up the utility bill? Do you just accept that you got a bad break in having lower base year expenses, and now that your pro-rata share has kicked in, the utility bill is way higher?
Solution: The “Gross-Up” Clause
Tenants in this situation can protect themselves by requesting a “gross-up” clause in their lease.
A gross-up clause limits your exposure to escalating variable expenses. It retrofits base year expenses to reflect a more fully occupied building.
Let’s say the base year utility expenses are $300,000 for that half-occupied building you moved into. As more tenants move in and the annual bill gets higher, a gross-up clause in your lease says that the $300,000 base year expense represents what the bill would be if the building were more fully occupied. Some landlords will use a range of 80%-90% occupancy.
By including a gross-up clause in your lease, you’ll be protected from significant spikes in variable expenses like utilities as the building fills up.
More Reason to Read Your Lease Carefully
As you can see, the management of base year expenses can potentially save (or cost) you thousands of dollars over the course of your lease term.
Don’t leave the base year up to the landlord to sort out. Make sure both your broker and your legal counsel negotiate and are on top of the base year expenses, projected expenses for all subsequent years, and how the landlord manages these expenses. Keep in mind that just like annual rent escalations, base year escalations can be renegotiated when you renew your lease. If these negotiations are going south, it may be time to find your next office space.