Corporate Real Journal Volume 6 Number 1

Commercial Office in the United States: Financial Risk Transfer And the Loss of Innovation

Terry Barger and Glen Wong Received (in revised form): 6th July, 2016 Terry Barger, Managing Principal, CyberLease LLC Glen Wong, Vice President, Transaction Sciences, Transwestern

Terry Barger received his Bachelor’s degree called to be an expert witness on the subject of from the University of Colorado and his MBA operating expenses. from Pepperdine University. He served nine years as a Marine Corps pilot, leaving with the rank of Glen Wong received his Bachelor’s and Master’s Major. His career in began at LaSalle degrees in Industrial and Systems Engineering Partners, a national asset management firm, as from the University of Southern California. He a General Manager responsible for the asset began his professional work in corporate real management of several high-rise office buildings estate at Walt Disney Imagineering. He subse- in Southern California. From this experience, he quently served as Vice President of Real Estate gained valuable insight into how esca- for Turner Broadcasting System and Senior late building costs and observed the general Director and Head of Corporate lack of specialised lease auditing expertise avail- at Invesco, overseeing their respective global able to tenants. He founded CyberLease in portfolios. He was then recruited by 1989 to meet this need. He instructs semi- the Foreign and Commonwealth Office of the nars for numerous real estate organisations United Kingdom to serve as Regional Asset including the Building Owners and Managers Manager for the Americas. He now practises Association (BOMA), the Institute of Real Estate as Vice President of Transaction Sciences at Management (IREM), the International Facility Transwestern, a real estate services and invest- Management Association (IFMA), and CoreNet ment firm. He is an editorial board member of Global. He has been an instructor for courses Journal and holds the accredited by various State Bar Associations Senior Leader of Corporate Real Estate (SLCR) for Continuing Legal Education (CLE) credit and designation from CoreNet Global. He has been State Departments of Real Estate (DRE) for con- an instructor for CoreNet Global, a lecturer at tinuing education of real estate professionals. Georgia State University and for the Real Estate He has been published on the subjects of com- Associate Program. mercial leasing and operating expense issues in the Journal of and in the ABSTRACT trade journal Office and Industrial Properties. He This paper focuses on the financial risks of the free- also co-authored the operating costs section for hold estate which have been transferred, through the book Negotiating and Drafting Office Leases evolving lease , to the , Corporate Real Estate Journal by John Wood and Alan Di Sciullo, published by within the context of the United States commercial Vol. 6 No. 1, pp. 1–8 © Henry Stewart Publications, Journal Seminars Press. He is frequently office industry. This reduction of an 2043–9148

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risk has occurred without diminishing the owner- This paper will focus on several of the ship right of receiving rent. This has significantly financial risks of the estate which changed the market equilibrium mechanism of have been transferred, through evolving lease estate rights and risks. As a result of this market contracts, to the leasehold estate, within the disruption, innovation in the leasehold property context of the United States commercial sector has been retarded for decades. office industry. This reduction of an owner- ship risk has occurred without diminishing Keywords: lease operating expenses, the ownership right of receiving rent. This financial risk transfer, evolution of US has significantly changed the market equi- leases, lease capital expenses, librium mechanism of estate rights and risks. enterprise risk, lease vs buy, innovation As a result of this market disruption, inno- vation in the leasehold property sector has been retarded for decades. DIFFERENT ESTATES IN PROPERTY HAVE DIFFERENT RISKS The principal estates in property are free- THE ALLOCATION OF FINANCIAL hold (of which, is the most RISKS OF A COMMERCIAL OFFICE commonly used type and hence practically LEASEHOLD ESTATE IN THE UNITED synonymous) and leasehold, each having STATES HAS CHANGED A GREAT their respective rights and risks. The rights DEAL TO THE BENEFIT OF THE of a freehold estate include the right to alter or sell the property, to receive the Some 40 years ago, the leasehold estates benefit of appreciation in value, to claim tax defined in commercial office leases in the depreciation, and to create leasehold estates United States generally produced a ‘fair and benefit from the related rent. The risks trade’ between landlord and tenant. For the of the freehold estate include the risk of landlord, its ownership rights allowed it to destruction and damage, of depreciation in lease a property and benefit from rent, while value, and of the economic costs of owning it retained the financial risks of having those and operating property. When the freehold ownership rights. For the tenant, its lease- estate owner uses its right to create a lease- hold rights allowed it to use a property, in hold estate and benefit from the related rent, exchange for the payment of rent, without the owner has also, historically, retained the taking on the risks of owning the property. related financial risks of ownership. These Through the late 1970s, under the terms rights and risks are theoretically held in of what was then called a ‘full-service balance. gross lease’, tenants only paid what was Prudent corporate real estate management then called ‘base rent’ in exchange for the considers the rights and risks of the freehold rights of a leasehold interest. That rent was and leasehold estates as they may support or a benefit to the landlord, which directly detract from the competitive advantage of flowed from its freehold estate right. The the enterprise. Enterprises that deliberately bargain then was that in exchange for choose to take a leasehold estate in property having that right, the landlord had the are presumptively electing to avoid the risks, financial responsibility for: and to forgo the rights, of a freehold estate. These enterprises are demonstrating they are Building operating expenses, which ‘not in the ’ and assume included: 1) utilities, repairs and main- that holding a leasehold estate obviates the tenance, property management, etc.; 2) risks of a freehold estate. insurance premiums and deductibles; and

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3) gross receipts, property and other ad by introducing the ‘Base Year’ concept into valorem taxes. leases. This concept fixed the landlord’s costs of ownership to those operating costs Capital expenditures. incurred in the first lease year (the ‘Base Year’, adjusted as necessary for a multitude Landlord enterprise costs such as: 1) its of reasons) and tenants pay in subsequent years own operational expenses; 2) marketing, for the increases in expenses over and above the advertising and leasing expenses and com- Base Year amount. Landlords thus effectively missions; and 3) its debt service. transferred the risk of inflationary increases in operating expenses to tenants. This was With the financial responsibility for these a simple mercenary move to ‘guarantee’ items, the landlord also held the financial a baseline of for landlords. Initially, risks. It was the commercial assumption that to reduce the impact of this innovation, tenants were not in the real estate business landlords agreed to offset the financial risks and therefore it was commercially agreed transferred to tenants by granting multi-year that the risks of ownership were the sole periods of non-escalating rents interrupted responsibility of landlords. by fixed rent increases at specific points Today, however, US leases have transferred during the lease term. After the accept- many of these financial risks of ownership ability of the innovation was broad enough, from landlords to tenants. These risks have even that accommodation was removed and been transferred incrementally over time, now tenants pay annually escalated rents often in response to macroeconomic changes AND annual increases in building operating that impacted owners negatively. New lease expenses. clauses were carefully crafted to minimise The next landlord innovation came with the appearance of the risk transfer while the introduction of a new type of lease called owner entities and their agents provided the office triple net lease (ONNN), begin- artfully reasoned rationales to reduce the ning in the late 1980s. In this type of lease, perception of the risk transfer. tenants pay for all operating costs without any offset such as is used in the Base Year lease. Thus, the Focus on three types of financial tenant’s risk was no longer limited to infla- risk transfer in commercial office tionary increases, but had increased to how leasehold estates: Building operating the landlord chose to manage its building. expenses, Capital expenditures, and Although the landlord continued to reserve Landlord enterprise expenses the freehold rights to define the scopes and performance standards of services, to choose Building operating expenses its service providers, and to pay these pro- In the late 1970s when full-service gross viders as it saw fit, it now made the tenants leases were standard, rents were often esca- responsible for the consequences of its exer- lated at stipulated rates, reflecting historic cise of these rights. During this time, it was assumptions of inflation of operating costs. not uncommon for ownership of a building When inflation rates increased dramatically, to change hands three or four times during a for some years over 10 per cent, landlords’ ten-year term. This often resulted in tenants operating profits were eroded. Landlords saw paying widely varying amounts under their their investment returns fall or become nega- leases, as each landlord operated the building tive as they absorbed the increasing operating in a different way. Some landlords increased costs of ownership. Landlords responded by building staff, changed management fees innovating a way to protect their returns or the ‘gross-up’ calculations for variable

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expenses, and added building amenity ser- complex and dynamic competitive business. vices. Because the landlord’s operating profit Note that a similar condition holds in the did not vary as operating costs increased, it had United Kingdom for internal repairing leases no direct financial incentive to manage these in multi-let premises, and full repairing and costs. Tenants which were already carrying insuring leases in single-let premises, but the the financial risks of operating costs in place ‘bond-like’ nature of the leases is enhanced at the beginning of their leases now began to by historically long lease terms, often lasting bear the financial risks of all operating costs 15 or more years. that might be incurred during their lease Protecting landlords from the risks of terms, including the risk that the landlord increased costs has transformed the land- poorly managed those costs on their ‘behalf’. lord’s expectations from its leasehold This landlord innovation also allowed the enterprise. Landlords now do not benefit increased costs of freehold estates that arise from decreased operating costs, so they have from their exchanges (sales) to be transferred lost their incentive to reduce those costs to leaseholders. Building sales frequently as a way to improve their own profit. As a trigger a tax value reassessment of the building. result, landlord enterprises lack innovation, Although tenants had no say in and received creativity and initiative. It has been regula- no benefits from the sale of a building, they tion and other external incentives that have were required to pay more in property taxes. changed landlords’ offerings in the property This is a cost of ownership from which marketplace: building codes, environmental tenants were no longer protected. standards and direct financial incentives have The terms and costs for insurance within replaced innovation in the industry. leases have also changed over the years. It is true that landlords do continue to Most leases now require the tenant to pay compete for new tenants in a market based for the landlord’s insurance for the landlord’s on the ‘gross’ rents each charges (base rent interest in the property, with no mutuality, plus operating expenses). An efficiently built as landlords explicitly are not required to and managed property will have lower oper- insure the tenants’ interests. Tenants are also ating expenses than a markedly less efficiently obliged to contribute to the rebuilding costs built and managed property. However, in a under a covered event, to the extent of static market where landlords are not respon- the uninsured costs limited by the insur- sible for operating expenses, competition ance policy’s deductible. But tenants are begins only when a landlord in the market not allowed to specify the terms or limits takes the initiative and risks the investment of coverage, or even the deductible. Having to increase efficiency, with no guarantee burdened tenants to this extent, landlords — of return (that is, a new tenant electing its almost comically — also require tenants to building over another in the market which reimburse the landlord’s cost of ‘loss of rents’ is less efficient). On the other hand, if all insurance coverage. landlords in a market benefitted directly, Many markets across the United States immediately, and with full assurance from have switched to the ONNN lease form as savings in operating expenses, their incentive it transfers a majority of the financial risks of to innovate and invest would be enhanced. ownership to tenants. This helped create the idea of a ‘rent coupon’ — that a landlord’s real Capital expenditures estate enterprise was, to the greatest extent The freehold estate provides the rights to possible and primarily, a simple and predict- receive tax and depreciation benefits of own- able bond-like financial instrument, and, ership, to retain the residual asset value of as little as possible and only secondarily, a the property and to be the sole beneficiary

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of any increase in the building’s value over expenditures by recharacterising them as time. These rights were balanced against the operating expenses through an expanded obligations and financial risks for all costs lease definition of ‘operating expenses’ associated with the purchase, preservation which included certain capital expenditures. and enhancement of the property. Therefore, For example, landlords unilaterally argued the cost of capital improvements, repairs, that it was not a fair bargain that the free- equipment and the like were excluded from hold estate absorbed the cost of a capital building operating expenses because those expenditure required by newly enacted capital expenditures preserved or increased which were beyond the landlord’s control. They the overall value of the underlying asset, created new bargains in creating leases that which value accrued to the freehold estate. required tenants to share in the risk of new As these rights and risks were reserved for laws enacted after lease commencement. the freehold estate, leaseholders did not Landlords unabashedly took the position reimburse landlords through lease contracts that they had no responsibility to bear the any part of such capital expenditures. With financial costs of the regulatory risks of this balance of rights and risks, landlords having a freehold estate, that is, of being created and maintained capital reserve funds in their chosen line of business. Hence, the to pay for the necessary capital improve- great majority of commercial real estate ments, repairs and expenditures to own and leases now include a definition of building operate their buildings. operating expenses similar to: From an accounting viewpoint, capital expenditures are those costs for goods and ‘Costs of a capital nature which are services which have a useful life over one incurred as a result of complying with year, are extraordinary, non-recurring costs laws, building codes, municipal ordi- and are significant in dollar amount. Thus, nances or other regulations enacted after landlords expected to incur the cost of the lease commencement date, provided replacement of a roof, security system or such expenditures are amortised over the HVAC system (among other things) at the useful life of the improvement.’ end of the useful life of each respective item. Because one of the risks of freehold estates Capital expenditures for cost-saving is that of changing legal or regulatory envi- improvements ronments, landlords also absorbed the cost of Some capital improvements may result in capital expenditures required to comply with a reduction of a building’s operating costs, new or existing building codes or laws. such as LED lighting or high efficiency With the success landlords had trans- chillers. However, due to the earlier inno- ferring the financial risks of operating a vation of transferring operating costs to property to tenants, they next turned to tenants, landlords did not benefit from such innovating ways to transfer to tenants the a reduction; tenants only bore the burden financial risks of required capital investments and reaped the benefits of innovations in in a property. Three cases of this type of building technology. Landlords predictably landlord innovation are discussed in the fol- argued that tenants who wanted a reduction lowing sections. of operating expenses achieved by a capital improvement were responsible for the costs Capital expenditures for government of those capital expenditures. The great mandated improvements majority of commercial real estate leases now In the mid-1980s, landlords started to include a definition of building operating charge tenants for certain types of capital expenses similar to:

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‘Costs of a capital nature which are building system, including air conditioning intended to produce operating cost systems, roofs, building facades and parking savings to the building provided such garages. In reality, these improvements are expenditures are amortised and provided generally required because the systems have further that the annual amortisation reached the end of their useful life. cannot exceed the annual savings actually achieved or reasonably estimated by the Capital expenditures for ‘stability of Landlord.’ services’ More recently, some landlords have inno- Capital expenditures for ‘safety vated by proposing the escalation of capital purposes’ expenditures which are necessary ‘for In the early 2000s, another capital expendi- the stability of services’ the landlord pro- ture provision was introduced, allowing a vides at the building. For example, at the landlord to escalate the annual amortisation commencement of the lease a landlord is of capital expenditures incurred ‘to enhance required to provide HVAC service, but or improve the safety of the building and/ after a number of years the HVAC system or its tenants’. At first glance, this seems fails; under this rationale, the landlord sensible, since tenants would want the land- can argue that the capital expenditures lord to take the necessary steps to make the needed to continue to provide those ser- building ‘safe’. This was another effort to vices should be charged to the tenant. atomise the costs of being a landlord and However, this concept is even more elastic make the tenant explicitly compensate the and ambiguous than the ‘safety’ provision direct costs of the landlord to run its busi- previously discussed. It is another land- ness. Further, the use of the word ‘safe’ is lord innovation, extending the scope of often not clearly defined and can be vague financial risks transferrable to the tenants. enough to encourage a landlord to under- Resting on language such as this, landlords take a whole host of capital improvements may effectively transfer all of the financial which a tenant may not find to be related risk of replacing any building system or to safety at all. In practice, this can lead to equipment which has reached the end of landlords taking advantage of their tenants’ its useful life. Actual cases of this include obligation to pay such costs under the terms $1.6 million to replace a HVAC system, of their leases. $800,000 for waterproofing the building Consider the case of a landlord which envelope (resealing the exterior glass), and renovated a building’s elevator system and $750,000 for an upgraded elevator system. charged the associated cost to its tenants. The landlord argued that because the eleva- Landlord enterprise expenses tors were becoming unreliable and therefore Following on their success in transferring ‘unsafe’, and with lease language which freehold financial risks to tenants, landlords allowed the landlord to amortise capital have also transferred some of the economic expenditures incurred ‘for safety purposes’, costs of being in the real estate business. One it was justified in charging the amortised cost example is the cost of debt servicing which as recoverable lease expense. In this case, this has traditionally been viewed as strictly an cost amounted to more than $100,000 per owner’s cost of financing its ‘inventory’ year for the next seven years. for being in the property leasing business. This rationale based on the ‘safety’ pro- However, a recent case1 may have an effect vision is too broad and opens the door on the future treatment of this category of for landlords to replace nearly any major expenditure.

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In this case, the landlord purchased a have been required by the landlord’s lender, building for $700,000,000 which was in the judge dismissed the case. The tenant excess of the value of the building when appealed the decision but lost the appeal on measured against other comparable build- the same grounds. ings in the marketplace. The new landlord This decision may set a precedent that obtained a secured loan for $500,000,000. In landlords may rely on in the future to justify order to obtain the remaining $200,000,000 the escalation of certain costs of financing of loan proceeds which exceeded the some types of debt service back to its market/replacement value of the building, tenants, even though a majority of real estate the new landlord had to purchase a ‘lease professionals would consider this an owner’s enhancement insurance’ policy (much like investment cost. Absent the inclusion of a private fee required specific lease language to the contrary, this for a residential if the buyer deposits is just another responsibility of ownership less than 10 per cent). The landlord passed which the tenant may now have to bear. the $8.3 million cost of this non-cancellable, ten-year, lease enhancement policy to its Conclusion tenants through operating expenses. In the United States, through the evolution In response, a tenant observed that the of lease language, it now seems that lease stated ‘any debt service under any most of the financial risks of a landlord’s mortgage on the Property and any financing freehold interest have been transferred to its or costs related thereto’ were spe- tenants, without a corresponding transfer cifically excluded from operating expenses. of rights or benefits. Coincidentally, new The tenant argued that if the landlord had United States accounting standards2 are going not purchased this insurance it would have into effect which will result in the been unable to obtain the loan and by car- of most real estate leases in ways similar to rying this coverage, was likely to reduce its owned real estate assets, that is, listing them borrowing costs as well. The classification of on balance sheets as an itemised ‘right of use’ this insurance coverage as a financing cost asset and a balancing liability. If enterprises is underscored by the fact that the policy are assuming most of the risks and costs of was non-cancellable, even in the event of owning real estate and have to account for another sale or refinancing of the building. property leases as if they were owners, might Therefore, it is inextricably tied to the it make more sense to buy instead of lease? financing and not the operation and main- If a leasehold is the preferred estate, then the tenance of the building. In reality, the policy tenant should attempt to carefully negotiate insures the $200 million of ‘excess’ financing all financial risk transfers, attending to pre- of the building and not the insuring of the cisely what the landlord is and is not able building itself. The tenant had to file a to include in expenses to the tenant. Often, legal suit, arguing the lease enhancement however, even the largest tenants cannot insurance was an owner’s costs of financing negotiate separate operating expense terms the building and should not have been than smaller but existing tenants in the same escalated. At court, the presiding judge property, due to the complications, admin- reviewed the lease and focused on the insur- istrative work, and risk for errors created by ance clause. The definition of insurance having different cost allocating mechanisms which was a part of the overall operating within one building. In any case, the tenant expenses to be escalated included ‘all costs should also scrutinise each reconciliation of insurance required by lender’. Since the statement and be ready to enforce the lease lease enhancement insurance was found to when necessary.

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In summary, thoughtful and effective cor- estate, to not be in the real estate business. porate real estate leaders should consider the Consequently, tenants in all kinds of busi- current allocation of financial risks between nesses have had to also maintain some form landlords and tenants. The current allocation of real estate property development business of such risks has changed the calculus around within their enterprise, otherwise known as the ‘risk premium’ of the fee simple estate. the Corporate Real Estate department. There Lease versus buy assessments for strategic seems to be an opportunity for a disruptive company locations may justify a ‘zero-based’ innovation which is actually a regression to risk assessment that explicitly considers these an earlier market model: landlords that retake risks. the traditional financial risks of ownership so Taking a broader perspective, it seems that that they can receive the financial benefits the history of landlord innovations in trans- that innovation can produce. ferring risks to tenants has worked to greatly reduce the generation of landlord innovations REFERENCES to provide better, more productive, or more (1) SSB REALTY LLC vs AMERICAN efficient, properties in the commercial office FINANCIAL REALTY TRUST & others marketplace. Tenants have absorbed these Court Case Number: 2010-P-0942, transferred financial risks while also taking on Commonwealth of Massachusetts Appeals the primary responsibility for innovating new Court. workplaces and infrastructure. This is contrary (2) Financial Accounting Standards Board to tenants’ intentions, by choosing a leasehold (FASB) 2016-02—Leases (Topic 842).

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