Negotiating your rental rate gets most of the attention in a commercial lease.
But another number can quietly become very expensive.
Operating expenses.
Property taxes, insurance, utilities, management fees, maintenance and other building expenses can increase throughout your lease term.
Depending on your lease structure, some—or most—of those increases may be passed along to you.
Fortunately, there’s something you can negotiate to limit that exposure.
The Operating Expense Cap
An operating expense cap limits how quickly certain expenses charged to tenants can increase.
For example, assum
e operating expenses are $10.00 per square foot and your lease limits annual increases to 6%.
If actual expenses jump to $10.95 the following year, the landlord may only charge you $10.60.
The landlord absorbs the difference.
Besides protecting the tenant, a cap gives the landlord an incentive to control expenses.
Sounds great.
But don’t stop reading.
The Fine Print Matters
Landlords typically try to limit operating-expense caps in two important ways.
First, they may insist
that the cap be calculated on a cumulative or average basis rather than strictly year-to-year.
That means a year in which there is a small increase can give the landlord room for a larger increase later. For example, if the cap is 6% and the expenses rise by only 2% one year and 10% the next year, the average is only 6% so the landlord can recover the full amount in the second year.
A strict annual cap is generally better for the tenant, although landlords rarely agree to it. A cumulative cap still provides valuable protection and is often a reasonable compromise.
The second issue may be even more important:
What expenses are actually subject to the cap?
Meet the “Uncontrollables”
Landlords generally exclude certain expenses from the cap because they argue they can’t control them.
Some make sense – Property tax
es. Insurance. Utilities. While the landlord has some control over these, they are mostly uncontrollable.
But landlords try to expand the list into questionable areas.
Management fees? Totally controllable.
Costs arising from governmental regulations? Only those enacted after the commencement date.
Security? Controllable exce
pt for emergencies.
Snow removal? Somewhat predictable based on where the building is located.
Anything “beyond the landlord’s reasonable control”?
That last one should get your attention. It feels like a blank check given to the landlord. I strongly resist that language.
The broader the definition of uncontrollable expenses, the less valuable your operating expense cap becomes.
Negotiate More Than the Percentage
When someone tells you, “we negotiated a 5% cap on operating expenses,” don’t celebrate just yet.
You need to know:
5% of what?
Which expenses are included?
Which are excluded?
Is the cap annual or cumulative?
Can the landlord recover increases in later years that exceeded the cap in earlier years?
A negotiated 5% cap isn’t particularly valuable if most of the expenses are excluded from it.
In commercial leases, sometimes the words surrounding the number matter more than the number itself.