DON THE LIFE JACKETS AND LOWER THE RAFTS (GOING OVERBOARD ON OPERATING EXPENSE EXCLUSIONS) RICHARD C. MALLORY

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1 DON THE LIFE JACKETS AND LOWER THE RAFTS (GOING OVERBOARD ON OPERATING EXPENSE EXCLUSIONS) I. INTRODUCTION. A. Dramatic Expansion. RICHARD C. MALLORY In 1970, a commercial lease may well have consisted of eight to ten pages, typed, double-spaced, plus a legal description and a one-page work letter as exhibits. In the 42 years which have followed, leasing attorneys have observed leases evolving to upward of 100 pages. One theory holds that when a down market occurred in corporate law, the practitioners would bring their "prospectus" approach to drafting into the commercial leasing arena, where billable hours were available, and leases expanded accordingly. The provisions relating to operating expenses were no exception. That these provisions grew significantly is not surprising, as operating expense is a lease category that encompasses a wide variety of issues. This Article includes a three-part Appendix: 1. Appendix 1 Landlord's Initial Operating Expense Provision - Landlord's initial draft of the operating expense related provisions of a commercial office lease; draft; and 2. Appendix 2 Tenant's Response - Tenant's response to landlord's initial 3. Appendix 3 Negotiated Final Operating Expense Provision - A negotiated final version of the operating expense section for this particular (redacted) lease. B. Resources. This Article has been prepared by drawing upon the following resources: 1. Mark A. Senn, Commercial Real Estate Leases: Preparation and Negotiation, Chapter 7 (5 th Ed. 2012). 2. ACREL Paper entitled "Common Area Maintenance Cost and Operating Expenses in the '90s-Emerging Points of Interests" by Ruth Barnes Himes. 3. ACREL Paper entitled "CAM/Operating Expenses, Devil or Angel So Who's Clause Is It Anyway?" by Thomas C. Barbuti and Alan A. Lascher. 4. The EMyth Blog, "Reducing Operating Expenses," January 28, 2009 (

2 5. Cox Castle & Nicholson's publication "Top Ten Issues in Common Area Expense Provisions in Retail Leases," Summer 2008 ( 6. The June 2, 2011 blog posting, "Six Reasons to Check Your Leases Operating Expense Bill," by Coy Davidson, Colliers International ( 7. Sharin and Lodgen's, blog article by Gray Buchman titled "Negotiating Inclusions and Exclusions from Operating Expense or Common Area Maintenance (CAM) Costs," posted November 7, 2012 at ( Inclusions-and-Exclusions-from-Operating-Expenses-or-Common-Area-Maintenance-CAM- Costs). 8. KBA Lease Services, Lease Tips-"Grossing Up Operating Expenses in Commercial Leases," July 12, 2011 ( Operating-Expenses-In-Commercial-Lease/). C. Landlord's Two Key Concerns. When a commercial lease is fully executed and delivered, the landlord's two key concerns are (i) Is the building financeable? and (ii) Is the building saleable? In the extremely rare circumstance where the lease is signed without any changes, the landlord is very comfortable that the lease will not denigrate the building's financeability or salability. All change requests to provisions in the landlord's initial draft of the lease are viewed through those twin lenses: financeability and salability. The fewer changes to the lease, the higher grade the landlord gives itself on the results of the negotiation. The landlord's view of "fairness" is measured in the same way; i.e., too much erosion of the twin goals of the landlord equals unfair. D. Assumptions. In this Article, there are two basic assumptions: 1. The tenant has moderate-to-strong leverage, meaning it has a solid credit rating, and it is taking the equivalent of five to ten percent of a building or project for at least five years. Change requests by the tenant that are discussed in this Article need to be seen in the context of these assumptions in order to be dealt with in a fair and full manner. 2. Given the assumptions in paragraph D.1 above, we can turn to the two basic underlying issues in negotiating operating expenses: What are they? How are they shared as between the landlord, the tenant and the other tenants of the building or project? II. HOW THEY ARE SHARED. Of the two underlying issues (1) what are the operating expenses, and (2) how they are shared the issue of how they are shared is the easier to tackle and will free us up to move on to -2-

3 issue no. 2. How they are shared is factual and is driven by the type of lease, the measurement of the space, (c) the gross-up language, and (d) the intensity of use. A. Type of Lease. In negotiating operating expenses, it is critical to understand the type of lease, which will typically be one of the following: a base-year lease, an expense-stop lease or a net lease. 1. In a base-year lease, the landlord is taking the risk of the first 12 months by setting the base rent to include the operating expenses for that 12-month period. The base year itself will be typically the calendar year in which the lease is signed, with the exception that if it is signed in the last quartile (September through December), the negotiation will typically result in the base year being the following calendar year. 2. In an expense-stop lease, the landlord is taking very few risks relative to the operating expense increases. If the assumption is that the operating expenses will be $7.00 per square foot, and the expense-stop is set there, then either the operating expenses are $7.00 per square foot or lower (but the rent will not move, so the landlord is keeping the delta) or (c) higher (in which the case the tenant is billed for the amount of the operating expenses in excess of the expense-stop). This will have to be considered a landlord favorite. 3. In a net lease, the manner and intensity of the negotiation of operating expense exclusions are minimized by the fact that the tenant will be paying all of the operating expenses allocated to its tenant percentage regardless of whether they are incurred in the first year or subsequent years. The marketing representatives of landlords utilizing net leases will be asked to estimate the operating expenses for a prospective tenant, and there is a possibility that the first or second year will include a provision that the operating expenses will not exceed a certain dollar amount. B. Measurement of Premises, Building or Center. Measurement standards vary across the country. The Real Estate Board of New York City ("REBNY") has its own measurement standards. The Building Owners and Manager Association ("BOMA") has a set of measurement standards that has been accepted by many states throughout the country, and internationally. And there are other lesser known measurement standards. The important factor is that the brokers are able to properly compare the finalists of the buildings which tenant would be willing to consider and then convert the rent to an apples-to-apples level so that a rational decision can be made in the building selection process. If the "usable" square footage of the premises ("you can carpet or tile it and put furniture on it") is satisfactory to the tenant, then the rentable square feet assigned by each particular building to that usable square footage calculation is the first step in comparing and contrasting the buildings. Tenants may select a less efficient building based on the ratio of the rentable square footage to the usable square footage because of a building's superior location and the physical amenities of the building, the proximity of retail to the building, visibility of exterior signage and the like. Among the tenant's most important concerns are employee attrition and the necessity of replacing them with new employees that need training; therefore, a more expensive -3-

4 building in a better location, given the higher degree of likelihood that employees will become long-term employees of the tenant, has value which will work its way into the selection equation. C. Gross-up. It is helpful to the landlord that the tenant can see that a landlord understands the gross-up concept and includes gross-up language in the lease, so that the tenant can be confident that its share of the variable expenses will be appropriate given the fact that its percentage of the building will not change. The lengthy discussion of the gross-up concept in Section 7.04 of Mark Senn's commercial leasing book is highly recommended, as is the gross-up blog which is referenced at Section I.B.8 above. It should be noted that the traditional GAAP or generally accepted accounting principles do not apply per se to real estate commercial lease accounting; rather, generally accepted accounting PRACTICES are applied and that will be discussed further in Section III.C of this Article. It is referenced here, however, in the context of the gross-up clause. If a commercial office lease has been signed and there is not a specific gross-up clause included in the lease, but if the operating expenses begin with words to the effect of the following operating expenses are "calculated pursuant to generally accepted accounting practices," then the gross-up procedure will be utilized regardless of its specific inclusion in the lease because that is the generally accepted accounting practice for dealing with variable operating expenses. D. The Intensity of Use. How operating expenses are shared by and among the various tenants of a building or shopping center is not necessarily a straight mathematical proposition of dividing the rentable square footage of the building or shopping center into the rentable square footage of the premises. If there is intensity of use of one or more elements of operating expenses in any particular premises within the building or project, the landlord should be expected to apply cost pooling concepts in order to fairly allocate the operating expenses by and among the tenants. The fact that a restaurant tenant should have a much higher proportion of the line item in the operating expenses assigned to it for trash removal is an obvious example of this concept. III. WHAT THEY ARE. A. Most of what is set forth in Section II above are factual matters. They require careful review and drafting, but they are factual. The square footage is factual if the measurement process is agreed upon. The use and intensity of use is factual, but the answer to just what ARE the operating expenses may be quite subjective, and it is the portion of the operating expense provision that calls for and receives the most attention and negotiation. B. Given our assumptions of the tenant's credit and the size of the space as set forth in Section I.D above, the parties should be able to agree on the language of all the inclusions and exclusions to operating expenses. -4-

5 C. Landlord's Initial Set of Inclusions. Let's start by looking at the set of inclusions shown in Appendix 1 which is in the landlord's initial draft of the lease. Then, let's turn to isolating what should be a "given" and what starts to get "gray". 1. Givens these inclusions in Section 4.2(1) of Appendix 1 will always be stipulated to and approved by tenants: Standard services and utilities, including heating, ventilating and air conditioning during business hours, tempered water, janitorial services and building standard bulbs. Repairs and maintenance performed by landlord (excluding replacements). an inclusion. 2. Gray can be successfully modified and thereby approved by the tenant as Insurance endorsements deemed necessary by landlord in order to repair, replace and/or recommission the building for LEED recertification. Costs of operating the parking facilities of the building. 3. Red Overreaching inclusions. Examples of these are: Amortization installments of costs required to be capitalized and incurred to comply with all directives of landlord's insurers, and Amortization installments of costs required to be capitalized and incurred to improve or maintain the safety, health or access of the project occupants and otherwise maintain the quality, appearance or integrity of the project. D. Tenant Push Backs on Inclusions. 1. Covered Already. Very little pushback should be required when the fact is that generally accepted accounting practices already modify an inclusion. An example of this is ground lease rent. Another is penalties due to landlord's violations of Law. The tenant will be entitled to these pushbacks even if the tenant does not raise the issue because the landlord is obligated to calculate operating expenses according to generally accepted accounting practices. 2. Fundamentally Reasonable. Some tenant push backs on the inclusions in an operating expense list are appropriate given all known factors and given the assumptions set forth above in this article for this tenant. No time should be wasted on items in paragraph D-1 above and this paragraph D-2 because the landlord should readily concede these, and such rapid concession will serve to build goodwill on the part of the landlord, aiding in its negotiations with -5-