increases. See 7.09 supra discussing the issues inherent with the sum of the demised and demisable premises in a building.

Transcription

1 19.03 Escalations Escalations are a form of additional rent. 1 Tenants are required to pay this additional rent to the landlord over and above base rent in order to reimburse the landlord for increases in operating expenses and taxes beyond the level established in the base year calculation. Escalations may also include other increases resulting from an inflation index. Escalation clauses are generally written in such a way that the costs to the tenant can never go down. In fact, the typical escalation clause covers only increases in costs and in the case of some leases, escalations are charged whether or not increases actually occur. Despite their importance, escalation provisions traditionally have not received the full attention they deserve in commercial lease negotiations. These provisions are often filled with vague and confusing language and complex mathematical formulas, making it very difficult to determine the monthly costs and the year-end reconciliation amounts. Generally the accountants are left to handle the calculations and the various problems which arise, long after the lease is signed. That is where the tenant makes his mistake. Once the lease term begins, the escalation provisions probably see as much or more activity than any other lease clause. Unlike renewals, expansions and terminations, which may take place only once during the entire lease term, the escalation billings take place as many as three or four times every year. Escalation provisions can substantially increase the tenant s expenses. The amounts are often compounded, resulting in rent obligations which increase quickly and in rather large increments. The escalation clause increases will vary depending on which formula is used. Some lease escalation clauses are tied to increases in real estate taxes, others to operating costs and still others are based on the Consumer Price Index, Porters Wage, or other formulas. Many billing disputes in commercial real estate leases arise because of vague lease language. To avoid unexpected liability, prevent unnecessary confusion and resultant disputes, the parties should be certain to have an attorney who specializes in commercial real estate leasing review any verbiage that has ongoing economic implications. 2 [1] Net and Not So Net Leases Some parts of the country have net leases, and some parts have not so net leases. Essentially, a net lease is one where the tenant pays a smaller base rent per square foot (presumably net of all base components), plus a percentage of operating costs and taxes for the building or complex, plus shared common area charges, such as maintenance, repairs, paving and lighting. 3 The percentage of these charges to be paid by the tenant is based on the percentage of the building that the tenant occupies in relation to all of the leasable areas in the building. 4 Under a not so net lease, there is generally a larger base rent figure, which includes the landlord s profit figure and other costs base components associated with the building s overall cost to run. Base rent should not include the expense of tenant operations within individual premises, however, there may be exceptions, such as rent inclusion electricity, of which the 1 As previously discussed, additional rent is anything that the landlord wants it to be. Escalations are the best known and probably the most expensive form of additional rent in office leases. 2 See: 19.03[5] infra for a discussion of tenant audit rights, 19.03[6] infra for a discussion of monitoring landlord escalation calculations and 19.03[7] infra for an escalations checklist. 3 These are pass through charges since they are to be paid net of any base amount. 4 These charges are not escalations or increases over base factors. They are based upon a percentage of actual increases. See 7.09 supra discussing the issues inherent with the sum of the demised and demisable premises in a building.

2 tenant should be very aware. 5 At any rate, when all these components are bundled into the base rent figure, it is easy to lose sight of what is there and how these calculations should work. During the base year, the landlord is expected to cover all its base costs, including debt service, under its base rent figure. After that, the tenant is expected to pick up its proportionate share of subsequent increases over the base amount (whether it be a base year, stop or stipulated base amount) figure for the remainder of its lease term. The challenge to the tenant is to determine whether or not the correct numbers are working into the escalation calculations. [2] Cost Comparisons Between Buildings Cost comparisons must be made between spaces available for lease in different buildings when a prospective tenant is shopping for new premises. Just as certain buildings have different usable to rentable square foot ratios, they also have different competitive advantages or disadvantages in the costs to operate them. For instance, there are many buildings in New York City that have real estate taxes in the $6.00 to $8.00 per rentable square foot range. There are also some buildings with real estate taxes of $12.00 per rentable square foot. Likewise, some buildings are incredibly disadvantaged when it comes to utility and electrical efficiency. Their costs per rentable square foot are much higher than those buildings that are new, high tech and energy efficient. Similar discrepancies occur with respect to operating and cleaning costs for buildings that are old, versus ones that are new; or with buildings that have very sharply negotiated positions in their cleaning contracts, versus ones that have brand new maintenance and operating contracts that are advantageous to unions. These numbers have to be examined and broken down. In addition, buildings may use different concepts of base years for calculating escalations. Some use the last year as a base year, while some buildings split years or half years. Some have fiscal years covering portions of two calendar years. Some have the current year of occupancy or the current year of the term, which can be considerably different. Some buildings pick next year, which could turn out to be a year and some months of actual possession by the tenant. Or some buildings may use a particular base year for a given escalation and another base year for another! In any event, care and attention should be given to these differences in order to have the definitions fully understood. The base year may be triggered by the contract portion of the lease term or it may commence upon the substantial completion of the premises when delivered by landlord to tenant. This can translate into an extremely large monetary difference and should be carefully considered and understood. In addition, there are some very subtle, but expensive differences, between office space in buildings in which different types of uses are present. Retail space, regional malls and mixed use buildings may contain some major costly landlord grabs. When examining a potential space to lease, these issues should be analyzed. [3] Taxes [a] Definition In order to determine what a tenant will be paying in the way of tax escalations, the tenant must understand the definition of taxes, as well as the amount over which it will pay the increases. It is not difficult to figure out what the base year or the base amount or factor for taxes 5 See 17.02[1] supra discussing rent inclusion electric factors. Under rent inclusion electric, a price per square foot is added to base rent or included in base rent (if so defined) as a charge for the landlord to supply electricity to the tenant s premises.

3 will be. These figures can be obtained from a tax assessor s office or they can be required to be verified within the lease. It is also a good idea to take the extra time to compare that figure to its component in the base rent just to see if the two figures agree. The more difficult concept, however, is calculating what taxes actually are. Simply, taxes are a payment made by a landlord, in most regions to a governmental or quasigovernmental agency, reflecting tax rates or mill levies applied to the assessed valuation of the property as determined by the government, plus any special or benefit assessments imposed on the property. Special assessments are generally imposed either in dollar amounts, rates or dollars times square foot area or numbers of people. Special assessments are generally levied to pay for land or improvements, such as sidewalk, traffic or sewer and water service, but may also arise to benefit transportation, landmark displacement or other special governmental or human services. They are usually paid in installments by the benefited district over the useful life of the benefit. [b] Method of Calculation The tenant must make sure that the base tax includes only that portion of the special assessments that falls within the base year period. All special assessments should be calculated upon the installment method to smooth out the impact over the term of the lease, whether or not the landlord pays them in installments. Note that landlords generally fail to include installments of special assessments in the base year. This seems to be a common practice. The affect is to shift more of the burden to the tenant by reflecting these installments as increases paid after the base year. The other prevailing method of calculating taxes is to multiply the valuation times the rate. Here the taxing authority determines the assessed valuation of the land and the assessed valuation of the improvements upon which a mill or a tax rate levy will be imposed. Land and improvements are generally treated differently. Land may be assessed at a full value and the improvements may be phased in or partially abated. Again the tenant should examine these figures with care. Some areas have different rates for taxes and special assessments. When calculating the taxes, especially for the base year, the tenant must make sure to understand thoroughly any reduction or limitation on the full amount of the assessed valuation of the land or the improvements by way of incentive abatements and the timing of when the land and the improvements become part of the assessment rolls when fully completed. In addition, the impact on base taxes should be adjusted, if appropriate, to avoid an artificially low base tax amount. Remember that the tenant will pay future escalations based upon the increases above this base. In some jurisdictions due to technicalities with the assessment rolls, an otherwise completed building with tenants in it may not be on the tax rolls at full value, irrespective of incentive abatements, for up to two years after it is actually physically completed. Even if the building is fully assessed, the assessed valuation may reflect additional abatements or deductions. Such an artificially low assessed valuation may occur through an incentive abatement program that erodes or becomes smaller with each year of the program allowing the assessed valuation of the land or the improvements to increase from year to year without regard to the actual increase in the value of the project due to market conditions. As has been pointed out repeatedly, the assessed value of a project can increase in several different ways simultaneously. Just as many buildings have different taxes, they also may have different base years, base factors, abatements and special assessments. Buildings also increase on the tax rolls at different times, for instance, when they are sold or refinanced. To try to calculate the impact of the base amount of taxes that will be paid by the landlord and the amount of increases each year, the tenant must dig into the existing taxable components of real estate and fully understand them all.

4 The components of assessable real property rights include the actual land, any improvements on the land, easements benefiting the land, encumbrances on the land (such as space leases or ground leases), air rights and unutilized development rights, income from the property, and types of use restrictions. Also to be considered are special assessments, free trade zones and payments in lieu of taxes. Only when all these factors are considered can the tenant arrive at the appropriate comparable number to weigh one prospective property against another. Once the tenant has determined the property s characterization and assessed valuation, 6 it can calculate what the taxes should be for the base year and estimate future escalations. In making these calculations, care should be taken to include only so much of the land as is necessary to support the building. Be cautious of the tendency of landlords in some of the larger cities to include the building containing the premises with other combined tax lots. When this occurs, the tenant will be paying taxes on excess improvable land and improvements that may be of no benefit to the tenant or may not be related at all to its use and enjoyment of the building. Remember that a garage, for instance, may be part of the building, but it may serve the public rather than the tenants. Similarly, there may be other buildings on the property that may or may not be assessed and may or may not be paying their freight on the combined tax lot. The tenant should sort out all these considerations and calculate which ones are relevant and fair. [c] Fluctuations Once it is understood how real estate taxes are computed and what will be the base amount of the taxes that the landlord will be funding, it is still not smooth sailing. A facilities manager or corporate real estate manager worth his or her salt will not allow taxes to increase because of additional improvements to the building other than those in the demised premises, nor will he or she allow the base taxes for the base year to be subsequently reduced and have all the subsequent years recalculated. Consider the following example. The tenant is paying $40.00 a rentable square foot, with taxes comprising $7.00 per square foot for the base year. But there is a little extra word or two inserted in the lease after the base year definition: as finally determined. In this instance, these three little words mean that in the second, third or fourth years or more, depending upon the appeal process for taxes in the particular region, the base year assessments may be redetermined and reduced. The tenant is still paying $40.00 per square foot of base rent. However, the landlord, after the adjustment, is only paying $6.00 per square foot as base escalation for taxes. Since the tenant is paying $7.00 per square foot in its base rent and the landlord is now paying $6.00, the landlord has a $1.00 per square foot savings in payments per year for the rest of the lease term. Moreover, since the lease clause allows the landlord to adjust the base year in the lease downward in subsequent years, the escalations payable by the tenant per square foot can increase. For instance, if in the second year after the assessed valuation adjustment, the taxes per square foot have increased back up to $7.00, the tenant will pay an additional $1.00 of escalation per square foot to reflect that increase, even though the tenant s base rent includes $7.00 per square foot for taxes. This is because the base year $7.00 figure had been adjusted downward to $6.00 for escalation purposes for all future years. The $40.00 base rent figure was not reduced to $39.00, however. This is a windfall to the ownership. 7 6 This is done after deducting any incentives and abatements, adding any installments or special assessments and determining what exactly the taxable lot consists of that the tenant should be paying for. This latter inquiry should include the building where the premises will be located, plus only so much of the land or improvements on the tax lot as benefits the tenant under the particular lease. 7 Side stepping the windfall for the moment, there are certain ownership costs associated with having new or empty buildings. Taxes are one of those ownership costs. Unlike operating expenses, which increase by usage of tenants and which may correlate to the usage by one singular tenant in the building, real estate taxes do not.

5 In this example, as strange as it may seem, the landlord has saved $1.00 per square foot and the tenant is paying an additional $1.00 per square foot. This will remain so for the remainder of the lease term. It is no small amount of money. Tenants should defend against this type of occurrence in the negotiation process and in the language of the lease. [d] Timing of Payments Only taxes paid by landlords should be paid by tenants and only as, if and when the landlords pay them. This is usually quarterly or semiannually and, provided that the tenant s check reaches the landlord in time to clear the bank before the landlord must pay the taxes, there is no compelling reason for taxes to be paid monthly or earlier by a tenant. Escalations should be based on taxes actually paid as opposed to the time they are assessed. If the taxes are subsequently forgiven before payment, there should be no payment required for that portion by the tenant. If forgiven after the payment, there should be a refund to the tenant of its share of that excess payment. The lease should allow for subsequent years tax review and reduction proceedings after the base year, recovery by the landlord of the portion of the cost of performing such review procedures and tenant recoupment of its fair share of the refund amount that was paid through escalations. [e] Tenant s Proportionate Share Some landlords think that if a building is not completely occupied, they should increase the occupying tenants proportionate shares of taxes so that the tenants are paying as if the building is fully occupied even though they may be the only tenants! Under this scenario, if a tenant is occupying half the building and its proportionate share of taxes is 50%, if it is the sole occupant of the building it will pay 100% of the increases in taxes. That will be a different result than having a tenant pay its proportionate share of 50% times the landlord s hypothetically assessed valuations based on a fully tenanted and occupied building with all tenant improvements and installations in place. Although there is some argument in favor of this theory with respect to operating expenses, there is no justification with respect to real estate taxes. Determining tax contributions can be a tricky business. There are so many variables. It is imperative that tax responsibility be stated clearly in the lease. In a New York case, the state Supreme Court upheld a lease clause requiring the commercial tenant to pay a disproportionate share of tax increases. 7.1 The court found that the lease set forth a simply unambiguous formula for determining the tax increase, to which the tenant agreed. 7.2 Even though the actual space occupied was significantly less than the deemed 6% of the building s area, the court noted that the tenant s space was deemed to be 6% and the lease specifically disclaimed that the figure bore any relationship [to the] precise amount of space in the demised premises and the space containing the building. 7.3 The court further noted that the impact of the future tax charges could be figured out simply by multiplying the hypothetical increase by 6 percent. 7.4 The plaintiff/tenant also tried to argue that the parties had unequal bargaining power. The court rejected that argument stating that the lease had been negotiated at arm s length by experienced Corporation v. Park Towers South Co., reported in New York Law Journal, p.18, col. 1 (N.Y. Sup. Dec. 8, 2005). 7.2 Mollen, Realty Law Digest, New York Law Journal, p.5-6 (Feb. 9, 2005). 7.3 Id., citing 609 Corporation v. Park Towers South Co., reported in New York Law Journal, p.18, col. 1 (N.Y. Sup. Dec. 8, 2005). 7.4 Id.