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Include Five Critical Operating Protections in Your Lease By Charles F. Martin III, Esq. I will explain these five critical protections and Charles F. Martin III, Esq., is a commercial real estate how you should address them in your lease. I will also attorney with Robinson & Cole LLP in Stamford, Conn. give you Model Lease Language for each of these He can be reached at (203) 462-7522 or protections that you can adapt and use in your lease. [email protected].

If you are like many office tenants, you focus hard on FIVE CRITICAL PROTECTIONS the specific items included and excluded from the def- inition of “operating ” in your lease. And for ❑ Make Owner ‘Gross-Up’ Certain Costs good reason, because the costs and expenses that are During Base Year included or excluded can greatly affect the amount of As a building’s occupancy rate rises or falls, certain money you will pay as “additional rent” over your operating expenses rise and fall, too, depending on the lease term. number of occupants in the building. These “occupan- Often overlooked, however, are five critical protec- cy-dependent” operating expenses may include such tions that have an impact on operating expenses and costs as electricity, garbage removal, and HVAC. that, if not included, can affect your bottom line as The occupancy fluctuations can lead to big well. increases and declines in total operating expenses, These protections are: which are the sum of the occupancy-dependent oper- ating expenses and also nonoccupancy-dependent ■ Gross-up protections; operating expenses—that is, those that don’t rise and ■ Limits on profits; fall with occupancy. ■ Caps on controllable expenses; If you have a base year lease (or “modified gross ■ Recalculation of your proportionate share; and lease”), it is not fair for you to pay a lot more or less, ■ Operating expense rights. however, just because the building’s occupancy rate These five critical protections are not particular to changes. You are still getting the same services, no the market you are in, the size of the lease transaction, matter how many other spaces are occupied. Gross- your creditworthiness, or any other factor. However, ing-up is a method that can prevent these big varia- every tenant—whether you are a Fortune 500 compa- tions. ny leasing 100,000 square feet in New York City or a When an owner grosses-up, it determines how small, start-up company taking much less space in the much each occupancy-dependent operating expense same market—can get these protections. would be if the building were nearly full—for exam- Because these protections benefit you, most often ple, 95 percent full. This evens out the occupancy- they will not be included in a typical owner’s lease dependent operating expenses in base year leases so form. Thus, you will need to discuss them yourself they don’t fluctuate with changes in the building’s with the owner. occupancy rate.

Reprinted with permission from the monthly newsletter, COMMERCIAL TENANT’S LEASE INSIDER, March 2007. 1 © 2007 by Vendome Group, LLC., 149 Fifth Ave., New York, NY 10010-6823. To subscribe call 1-800-519-3692 or visit www.vendomegrp.com If you have a base year lease and are paying your incurred by Landlord had the Building been at least proportionate share of operating expenses over a base ninety-five percent (95%) occupied and Landlord had furnished such services to at least ninety-five percent year, make sure that, during the base year, the owner (95%) of the Building. grosses-up: ■ All occupancy-dependent expenses; and ❑ Don’t Let Owner from Operating Expenses ■ The costs of all services and utilities that other The owner should not make any profit from operating tenants are paying separately—such as tenants paying expenses. Therefore, include a clause prohibiting the their electric bills directly to their utility company. owner from collecting an amount greater than your If those expenses and costs are grossed-up only fair share of the operating expenses. after the base year, but not during the base year, you Model Lease Language could end up paying a share of huge increases in oper- Landlord agrees that Landlord shall not collect from ating expenses over the base year. Tenant an amount greater than Tenant’s Proportion- ate Share of the Operating Expenses actually paid by Example: A lease requires you to pay your propor- Landlord in connection with the operation of the tionate share of increases in operating expenses over a Building and Landlord shall make no profit from Land- base year. If the building were fully occupied, the lord’s collections of Operating Expenses. owner’s annual tenant-related cleaning expenses Also, limit the collection of operating expenses to would be $100,000. But the building’s occupancy rate owner’s actual and reasonable operating expenses. in the base year falls to 50 percent, so the cost of the Finally, try to eliminate any catch-all phrases in the owner’s cleaning services for the base year is only definition of operating expenses that let owners back $50,000. in additional operating expenses not specifically set out in the lease. Examples of such phrases include: The lease requires the owner to gross-up to 95 “any other cost or expense of operating or maintain- percent all occupancy-dependent expenses every year ing the Property,” and “expenses paid or incurred by after the base year when the building’s occupancy rate owner for the operation of the Property, including falls below 95 percent. If the building is 100 percent without limitation. ...” occupied during the second year of the lease term, the owner’s cleaning costs will jump to $100,000. You are stuck paying your share of that $50,000 ($100,000 - ❑ Limit Controllable Expenses $50,000) increase in cleaning services. Try to place an annual cap on increases in operating expenses that the owner can control—such as building However, if the owner were required to gross-up personnel salaries, building service contracts, and such occupancy-dependent cleaning expenses during management fees. Otherwise, these expenses could the base year, cleaning services during the base year get out of hand and you could end up having to pay would have been $95,000, instead of $50,000. Thus, your share of a huge bill. you would pay your share of only the $5,000 ($100,000 - $95,000) increase in cleaning services in For instance, add the following language to your the second lease year. lease, but make sure you define “Controllable Expenses” elsewhere in the lease: Clarify in the lease that the owner must gross-up operating expenses in the base year, as well as any Model Lease Language Tenant shall have no liability for increases in Control- year thereafter in which the building is less than 95 lable Expenses of more than [insert percentage] in percent occupied: the aggregate per annum, on a cumulative basis, over $[insert base year dollar amount]. Model Lease Language If, during any lease year, including, without limitation, the Base Year: ❑ Recalculate Proportionate Share if (i) The Building is less than ninety-five percent (95%) Building’s Size Increases occupied; or An obvious and fair thing to do is to put a clause in (ii) Landlord shall furnish any service to less than ninety five percent (95%) of the Building, whether your lease requiring the owner to recalculate and because another tenant is separately paying for reduce your proportionate share when the rentable services or utilities furnished to its premises or area of the building where your space is located otherwise, increases. The reduction in proportionate share could then Operating Expenses shall be increased by Land- end up significantly lowering your operating expense lord to reflect ninety-five percent (95%) of the Oper- ating Expenses that would have been reasonably bills.

Reprinted with permission from the monthly newsletter, COMMERCIAL TENANT’S LEASE INSIDER, March 2007. 2 © 2007 by Vendome Group, LLC., 149 Fifth Ave., New York, NY 10010-6823. To subscribe call 1-800-519-3692 or visit www.vendomegrp.com The reduction in your proportionate share should ❑ Get refund of overpayment. If the statement take effect when the owner receives a certificate of from the owner shows that the actual operating occupancy for any new rentable space in the building, expenses for the prior year were less than what you or when any tenant occupies such new space for its paid, the owner should promptly refund your over- purposes, whichever occurs first. If certifi- charge. cates of occupancy are not issued by the municipality ❑ Get enough review time. Make sure the owner or another appropriate government authority in which gives you enough time to review its statement of oper- the space is located, the trigger should be the docu- ating expenses, so that you can decide whether to ment or event that legally allows a person or company challenge it. Typically, if you don’t challenge an to occupy the space. owner’s statement within a set period of time, you will Model Lease Language be deemed to have accepted it and will lose your right If the rentable area of the Building shall at any time exceed [insert rentable square footage of building on to challenge it. Therefore, try to give yourself at least the lease’s commencement date], Tenant’s Propor- 90 days to review the owner’s statement and decide tionate Share shall be recalculated and reduced by whether you want to dispute it. dividing the rentable square feet of the Premises by the new rentable square feet of the Building. Prompt- ❑ Get access to books. Require the owner’s ly following any such increase in the rentable area of the Building, Landlord and Tenant hereby agree to books and records to be available to you at reasonable execute and deliver to each other an amendment to times and at reasonable locations. For instance, if your this Lease memorializing the reduction in Tenant’s lease is for space in Florida and the owner’s offices Proportionate Share. are based in California, it would be a long haul to the If the owner is not required to recalculate your West Coast. In fact, that scenario would probably dis- proportionate share when the rentable area of the courage you from exercising your audit right. building increases, you may be stuck paying operating ❑ expenses using the old proportionate share, unless you Get owner to pay your costs. If the owner has want to spend the time and money to litigate the mat- overstated operating expenses by at least some thresh- ter in court. In most states, commercial leases are old amount—usually between 3 percent and 5 per- nothing more than contracts, and the parties can nego- cent—require the owner to pay for your audit costs. tiate any terms they want, provided those terms don’t Further, if you have enough leverage in the lease violate the law or public policy. negotiations, fight for the right to receive interest on all overcharges. ❑ ❑ Get Right to Audit Owner’s Books Submit disputes to arbitration. If you and the Make sure you include a clause in your lease that owner can’t agree on whether there has been an over- gives you the right to audit, review, and challenge the charge or undercharge of operating expenses, get the owner’s calculation of operating expenses. That will right to submit the matter to a mutually acceptable help keep the owner honest, and it gives you the right arbitrator or mediator. to obtain a refund for any overcharges. Model Lease Language If Landlord and Tenant are unable to agree whether Here is a short checklist to run through each time an overpayment or underbilling of Operating Expens- es has occurred, or on the amount of such over- you negotiate for audit rights. charge or underbilling, then either Landlord or Tenant ❑ Detailed statement. Require the owner to may submit the matter to arbitration in accordance with Clause [insert # of arbitration clause] of this deliver to you within 30 days to 60 days after the end Lease. of each lease year a detailed statement of its actual Ideally, the arbitrator or mediator should have at operating expenses for the prior year. You don’t want least 10 years of experience in handling such disputes the owner to drag its feet in giving you this informa- in the relevant market. tion, especially because the statement may indicate that the owner overcharged your operating expenses. For more information on what to include in an Model Lease Language audit clause, see “Get Effective Lease Right to Audit Within [insert #, e.g., thirty (30)] days after the end of Owner’s Books and Records,” Insider, March 2005. each Lease Year, Landlord shall deliver to Tenant a You can also download this article from the Real detailed statement setting forth the Operating Expenses actually incurred by Landlord for the prior Estate section of Vendome Group’s Web site, Lease Year. www.vendomegrp.com. ■

Reprinted with permission from the monthly newsletter, COMMERCIAL TENANT’S LEASE INSIDER, March 2007. 3 © 2007 by Vendome Group, LLC., 149 Fifth Ave., New York, NY 10010-6823. To subscribe call 1-800-519-3692 or visit www.vendomegrp.com