Updated February, 2018
When it comes to determining your operating expenses as a tenant, one of the most important yet commonly overlooked stipulations in your lease is the “base year.” The base year is a key framework for how you, as a tenant, pay for building expenses.
In a full service or modified gross lease, tenants pay base rent for the first year of occupancy, with no portion of the building’s operating expenses included in that rent. You can expect base rent in a full service gross lease to include tax, insurance, utilities, in-suite janitorial, and Common Area Maintenance (CAM). Modified gross leases typically exclude utilities, in-suite janitorial, and CAM.
Because of a base year clause, both of these types of leases become more or less the same after the first year of operation. For all subsequent years of their lease term, tenants with either a full service or modified gross lease will both pay a pro rata (proportionate) share of the building’s operating expenses.
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. 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.
Base Year and Pro Rata Share
For the first year of your 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. Seems relatively straightforward, 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. That means, if the year following the base year sees an increase of operating expenses of $100,000, you have to pay your pro rata share of $100,000. Using the previous example of 10% occupancy, your share of operational expenses in the second year of your lease would be $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 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.
Remember those CAM expenses from earlier? These expenses, like 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. A landlord looking to save money on those expenses will defer maintenance in these areas until your base year has come to an end — or longer.
For example, a landlord might decide to delay installing that new HVAC system until you’re a year out from your base year. In which 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
Office rents 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. Then, 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.
Scenario Two: Variable Expenses
The other area where tenants can get burned is regarding occupancy rates and increasing expenses based on usage (called “variable” expenses).
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 with 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.