Understanding, Preparing & Grossing Up Expense Escalations

Understanding, Preparing & Grossing Up Expense Escalations Presented to The Real Estate Law Section of The by William H. Brownfield, CRE, CCIM www.escalationadvisors.com

Understanding, Preparing & Grossing Up Expense Escalations I II III IV V VI Escalations - How Much? Why Are Escalations Necessary? Gross Ups, Capital Amortizations & Expense Caps Office, Retail & Mixed Use Audits Who Needs Them? How Can HBA Improve Escalations? Questions & Answers 2

I. Escalations How Much? U.S. Private Sector Office Space (Source: BOMA & NewmarkGrubbKnightFrank, Research Div) ~11 billion sf % of Building s Income* Base Year Leases (~60% of leases) 10% - 20% NNN Leases (~40% of leases) 40% - 50% * Average accumulated at mid-term of 2.5 years Our Best Estimate? (Equivalent to AT&T s or Verizon s annual revenue) ~ $ 130 billion 3

II. Why Are Escalations Necessary? Purpose of escalations? Types of clauses? Major Changes in Lease Language?

Purpose of Escalations from a Landlord s Perspective Economic Commercial leases are long-term, so the LL needs to protect the Net Cash Flow of the lease from inflation during the lease term to preserve property s value Tenants benefit from the services - Tenants should bear the cost increases associated with those services Another way to look at it: Escalations for an Office Lease serve the same purpose as Change Orders do for a Construction Contract Summary Escalations keep the Landlord whole (at least that s the objective) 5

Purpose of Escalations from a Tenant s Perspective Escalations equal each Tenant s share of building s operating expenses. Lease establishes the Tenant s Pro-rata share of the building as an equivalent percentage of the building s operating expenses Pro-rata share is a valid concept only if the percentage is applied to a full building s operating expenses. This is the justification for grossing up variable expenses (those that vary with occupancy). 6

Basic Types Of Lease Escalation Clauses Net (NNN) Lease Tenant pays all operating expenses (its pro-rata share). The tenant bears all of the costs & the risk of inflation. Tenant pays lower base rent but more in escalation charges. Base Year Lease The point at which the landlord stops and the tenant starts paying expenses. > Base year utilizes the actual, grossed up expenses for a specified year LL typically bears the risk of inflation in Year 1 & Tenant thereafter. Base Year - Variations: > Expense stop specifies a negotiated dollar amount psf > BY + E The Base Year includes Tax & Operating, but not Electricity Total Rent is the same under all of these types of lease clauses 7

NNN Leases In recent years, many cities converted to NNN due to strong Landlord markets tied to job growth ~ 40% NNN up from ~ 15% 20 years ago Common Problem: Expenses quoted by the LL s leasing rep during lease negotiations don t match current or next year s Grossed Up expenses. Why? Budgets are prepared by the Management Co., not by the Leasing Co. Goal: LOI s expense est. should match grossed up expenses in Year 1 of the lease Also: Weak markets gravitate back toward Base Year leases 8

Base Year Leases More Variations Combined Taxes and Operating Expenses Real Estate Taxes & Operating Expenses are combined in BY amount. A decrease in one will offset the increase in the other category. Advantage: Goes to tenant if Taxes or Operating Expenses decrease Separate Taxes and Operating Expenses Leases stipulate that Real Estate Taxes and Operating Expenses are billed separately with separate BY amounts. Advantage: Goes to the landlord if either category decreases Taxes Only Lease (often GSA) includes clause that only allow real estate taxes to be escalated. 9

Major Changes in Lease Language? Not Many Texas Franchise/Margin Tax Language Permitted Operating Expenses (cont.) (9) the cost of reasonable legal and accounting fees: (10) all taxes, assessments and governmental charges, whether or not directly paid by Landlord ~~~~~; provided, however, that if at any time during the term of this lease, the present method of taxation or assessment shall be changed so that the whole or any part of the taxes, assessments, levies, impositions or charges now levied, assessed or imposed on real estate and the improvements thereon shall be discontinued and as a substitute therefor, or in lieu of or in addition thereto, taxes, assessments, levies impositions or charges shall be levied, assessed or imposed, wholly or partially, as a capital levy or otherwise, on the rents received from the Property or the rents reserved herein or any part thereof, then such substitute or additional taxes, assessments, levies, impositions or charges, to the extent so levied, assessed or imposed with respect to the Property, shall be deemed to be included within the Operating Costs. ~~~ 10

III. Gross Ups, Capital Amortizations & Expense Caps General themes 1. Why Gross Up? Is the myth true: Does the LL collect more than is spent? 2. Capital Amortizations: Why would a Tenant agree? How much - or how little - is actually recovered? 3. Types of expense caps?

Three Reasons to Gross Up #1 Grossing up Protects The tenant during periods of increasing occupancy And Protects The landlord during periods of decreasing occupancy Because both are tied to the pro-rata share concept 12

Three Reasons to Gross Up #2 Adjusting a building s expenses to reflect full occupancy (grossing up) creates a method of comparing expense increases (escalations) from year to year #3 When administered properly, Grossing up is fair for both the Tenant & the Landlord* (*true unless abused with NNN leases most leases require that the LL will not collect more in expense recoveries than the LL actually spent) 13

Fixed expenses ($6.00 psf) incurred even at zero occupancy. Gross Up amount ($4.00 psf) increases Total Grossed Up Expenses to $10.00 psf Variable expenses (triangle) incurred as occupancy moves from 0% to 100% Recovered expenses (blue line) pro rata share of $10.00 psf, based on actual occupancy Total Expenses TOTAL GROSSED UP EXP = $10.00 OPERATING EXPENSES Comparison of Actual vs. Recovered Expenses for a NET Lease $ 10.00 FIXED EXP = $6.00 $ $ $ $ $ $ $ $ 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 GROSS UP AMOUNT TOTAL ACTUAL EXPENSES @ ANY OCCUP. VARIABLE EXPENSES RECOVERED EXPENSES @ ANY OCCUP. $ 1.00 $ 0.00 0.00% 25% 50% 75% Percent Occupied 100% The Myth is Wrong: Recovered Expenses (blue line) never equal Actual Expenses (red line) until 100% occupancy 14

Capital Amortizations Questions Why would a Tenant agree to pay them? Lease Language? GAAP? How much (or how little) is really recovered? What s Base Year Inflation? How do you avoid it? Capital amortization or R&M expense? 15

Capital Amortizations Why Would a Tenant Agree to Pay Them? LL is generally allowed to pass thru CapEx costs that: a) Reduce operating expenses b) Keep the property Code Compliant Tenants benefits by allowing the LL to recover these Capital Expenditures because they benefit from lower operating costs during the lease term. 16

Capital Amortizations Lease Language - GAAP Most leases include a GAAP* clause for Capital Improvements GAAP defines a Capital Improvement as an expenditure that: Extends the useful life of the asset beyond the original life, or Materially increases the value of the asset above its current book value ( just vague enough to create a lot of arguments) If neither, it is typically categorized as a Major Repair usually fully expensed in the year incurred. e.g. chiller repair or patching the roof *GAAP (Generally Accepted Accounting Principles) Rules used by public companies to match revenues with corresponding expenses The GAAP Guide makes ABSOLUTELY NO REFERENCE to OpEx or Escalations 17

How Much Capital Is Actually Recovered? Function of 3 Variables 1. Lease Rollover Schedule 2. Amortization Period 3. Occupancy each Year of the Amortization Period for each Capital Item LL s recovery is usually far below 100% of cost 18

How Much Capital Is Actually Recovered? Exhibit 6-3 SAMPLE CUMULATIVE CAPITAL RECOVERY BY AMORTIZATION PERIOD OF A ONE DOLLAR CAPITAL EXPENDITURE Amortization Period 1 Year Rollover Recovery % 2 Years Rollover Recovery % 3 Years Rollover Recovery % 4 Years Rollover Recovery % 5 Years Rollover Recovery % Amount Recovered by Year Cumulative Year 1 Year 2 Year 3 Year 4 Year 5 Capital Recovery $ 1.00 x 80% $ 0.80 $ 0.80 80% $ 0.50 $ 0.50 x 80% x 60% $ 0.40 $ 0.30 $ 0.70 70% $ 0.34 $ 0.33 $ 0.33 x 80% x 60% x 40% $ 0.27 $ 0.20 $ 0.13 $ 0.60 60% $ 0.25 $ 0.25 $ 0.25 $ 0.25 x 80% x 60% x 40% x 20% $ 0.20 $ 0.15 $ 0.10 $ 0.05 $ 0.50 50% $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20 x 80% x 60% x 40% x 20% x 0% $ 0.16 $ 0.12 $ 0.08 $ 0.04 - $ $ 0.40 40% Assumptions: 1. A $1.00 Capital Expenditure, assuming different amortization periods. 2. 100% Occupancy during the 5 year term 3. 20% Lease and Base Year Rollovers (i.e. Same Rollover Recovery percentages as in Exhibit 6-2) 19

What s Base Year Inflation? It Can Also Reduce CapEx Recoveries Due to combining Operating Expenses and Capital Amortizations into one Base Year for Tenant However Capital Amortizations can expire in the middle of a Tenant s lease term Result: Grossed up expenses drop below the Base Year, preventing the LL from recovering any inflationary increases until expenses exceed the Base Year (if ever) Very common problem overlooked by most owners 20

How To Avoid Base Year Inflation? Solution: Separate & Escalate Add language to clarify that CapEx is excluded from Base Year and Escalation calculations See Page 48 of the Handbook 21

Capital Amortization or R&M Expense? Your standard lease allows cost-saving capital improvements to be escalated over the payback period, and code required improvements over their useful life. How would you treat each of the following costs? 1. $75,000 to tear-off and replace the roof which has a useful life of 15 years 2. $7,500 to patch and recoat a section of the roof which was replaced 3 years ago 3. The Chiller was replaced in 2000 at a cost of $250,000 with a useful life of 20 years. As part of its 5 year tear down in 2005, you replaced several chiller bearings and seals at a cost of $17,500 4. A change in the Fire Code required you to add elevator recall buttons at a cost of $40,000 with a useful life of 10 years 5. A change in the Fire Code required you to add signage in each elevator at a cost of $400 with a useful life of 10 years 6. $125,000 for an Energy Management System which is expected to save over $40,000 per year in electricity expense and has a useful life of 20 years. 22

Types of Expense Caps Escalation Clauses That Limit Tenant Risk Expense Caps Leases clauses that limit annual increases in expenses paid by a Tenant. (e.g. Operating expenses will not increase more than 6% above prior year) Controllable Expenses ARE subject to the Expense Cap Many operating expenses are considered to be controllable because the landlord has a choice of vendors and service levels. Excluding Certain Expenses from the Cap Non-Controllable Expenses (e.g. taxes, insurance and utilities) Some expenses are deemed to be out of the landlord s control, such as taxes and certain utilities. Cost increases are often determined by factors unrelated to the building s operations. Typically EXCLUDED from expense cap. 23

Annual Cap (favors tenant) Types of Expense Caps The lower of: actual expenses or the capped expense amount from the previous year. It limits the percentage increase over the prior year s allowable/billable expenses. Cumulative Cap (favors landlord) Grows from the first year s actual expenses. It limits how much operating expenses can increase each year on a compounded percentage basis over the first year. Key difference: what happens in future years if expenses go down? Annual Cap example (10%) Year Actual $ s Cap $ s Allowed 2010 $100,000 $100,000 $100,000 2011 $115,000 $110,000 $110,000 2012 $112,000 $121,000 $112,000 2013 $130,000 $123,200 $123,200 2014 $140,000 $135,520 $135,520 Cumulative Cap example (10%) Year Actual $ s Cap $ s Allowed 2010 $100,000 $100,000 $100,000 2011 $115,000 $110,000 $110,000 2012 $112,000 $121,000 $112,000 2013 $130,000 $133,100 $130,000 2014 $140,000 $146,410 $140,000 Each year, pick the lower of Actual $ or Cap $ 24

EXPENSE CAPS WHICH IS BEST? Short Answer: All caps benefit the Tenant, not the Landlord Landlords: Get a Cumulative cap on controllable expenses Tenants: Get an Annual cap on most expenses, but accept a Cumulative cap on controllable expenses 25

IV. Office, Retail & Mixed Use Similarities, Differences & Trends Office & Retail Comparison Mixed-Use Types Allocation Methods Sample Property Trends

Comparison Office Escalations vs. Retail CAM Office Fixed pro rata share based on rsf building denominator Variable expenses grossed up No Admin Fee Landlord pays for utilities and cleaning, but recover thru esc. Landlord uses standard lease form (although large tenants typically make revisions) All tenants pay for both interior and exterior cam Retail Variable pro rata share based on leased area No expense gross ups Typical 10%-15% Admin Fee Tenants pay their own utilities and cleaning Anchor tenants given extremely favorable terms and use their own national lease forms Outparcel stores only pay for exterior cam 2016 Brownfield & Mayerhofer, Inc

Mixed-Used Property Combinations Office Building(s) Retail Parking Garage Hotel Residential (condos or apartments) Cost Sharing between properties with different owners but common needs, related to condominiums, common area, reciprocal easements or master agreement (typically landscaping, security, taxes) 2016 Brownfield & Mayerhofer, Inc

Allocation Methods Defined By Major Themes Ownership Structure Physical Structures Usage and/or Consumption Written or Oral Agreement 2016 Brownfield & Mayerhofer, Inc

Allocation Methods Defined By Physical Metrics Pro rata Share Square Footage (landscaping) Equal shares Drive-by security service Actual Usage Allocated spaces in a parking garage, or staff timecards Headcount Water for outdoor restrooms Fixed % Insurance REAs Common Area taxes Tax Value Specific taxes 2016 Brownfield & Mayerhofer, Inc

Typical Mixed-Use Allocation SAMPLE COMMON AREA EXPENSE ALLOCATION MATRIX Scenario: Complex includes a 100,000 sf office building, 50,000 sf of ground floor retail, and a 50 unit hotel all sharing a common lobby, pedestrian plaza, and a 375 space parking garage. Repairs and Maintenance 33% 34% 33% Equal shares Landscaping 33% 34% 33% Equal shares Elevator Expenses 50% 0% 50% No retail elevators (ground floor only) Security Expenses 20% 35% 45% 24/7 for hotel, 12/7 for retail Parking Expenses 20% 50% 30% Based on allocation of spaces Electricity 25% 50% 25% Outdoor lighting & lobby electric only Water/Sewer 20% 40% 40% Based on meter readings Insurance 40% 25% 35% Based on replacement cost Real Estate Tax 32% 38% 30% Based on assessed valuations Major Repairs 34% 33% 33% Equal shares Landscaped Park Ground floor Retail (total 50,000 rsf) Percent Allocation Pedestrian 5 story Account Group Office Retail Hotel Justification Plaza Office Administrative 60% 30% 10% Based on survey of staff requests 3 story Building Hotel Shared (100,000 Cleaning/Supplies/Dayporter 35% 30% 35% Lobby & walkway cleaning only (50 units) Lobby rsf) Rubbish 25% 35% 40% Based on trash output Retail Pedestrian Walkway 3 Story Parking Garage (375 spaces) 31

V. Audits Who Needs Them? No Standards-GAAP+Errors = Audits A War Story Worst-Case Audit How Can Landlords Improve?

Standards for Calculating $130 Billion? Industry regulations applicable to escalations? NONE Accounting regulations applicable to Cap Ex? GAAP GAAP criteria specifically applicable to escalations? NONE Accounting Software with BOMA s Endorsement? One What Do Most Landlords Rely On? In-House Result = Lots of room for Errors & Disputes Our estimate: Most escalation invoices have errors Three primary reasons Complexity, Software & Invoices 33

Why Do Errors Occur? The Conceptual Answer Complexity, due to the interplay of 3 silo disciplines Legal, Accounting & Property Management The Lease - Establishes the concepts but not the methodology Property Accountant - Understands the numbers but not the operations Property Manager - Operations determine gross-ups. Understands operations, but often not the accounting or the legal concepts established in the lease. Need to understand all 3 to create the methodology 34

Why Do Errors Occur? The Software Answer Almost every Landlord uses different methodology: Integrated Software Enterprise & portfolio software. Which software makes the cut is often decided by HQ committee (not PMs) & administered by IT departments whose mandate is to reduce # of platforms used. Accounting Software Packages (ex. Yardi, MRI) Many do have an Esc module, but assume all leases are the same. (CFO picks) Homegrown Excel schedules Almost everyone. Some better than others, but all are prone to formula changes & hidden errors. (template by CFO or Controller) 35

Why Do Errors Occur? The Invoice Answer Who Prepares the Invoices? The owner s attorney? The property accountant? The property manager? The Administrative Assistant Classic mistake of not aligning authority & responsibility 36

Why Do Tenants Audit? Better question: Why Not? Here s Why Company policy EOP 100 125 per year ( ~ 1% of RR) Past billing mistakes General mistrust: Landlord vs Tenant Syndrome Because they know: The AA is doing the calculations? They understand the maxim: Trust but verify How can Landlords survive an audit? Assume you will be audited, keep detailed records Be consistent year after year Use standardized escalation methodology 37

A War Story. Worst-Case Audit The Players Houston Landlord National Tenant Contingency auditor (non-cpa) 33% contingency fee for the auditor, based on submitted Claims, regardless of settlement The Auditor s Output 5 pounds of paper Claim for $186,000 Made LL The Bad Guy & deemed Guilty until they proved themselves innocent Report used by Tenant to threaten litigation & lease termination 38

A War Story Worst-Case Audit Review of Methodology The Landlord s Methodology No Gross Ups in Base Year or Year 2 Inconsistent Gross Ups Thereafter Percentage Adjustment Approach Arbitrary capital amortizations Result: (some items not escalatable) The LL overcharged the Tenant 39

A War Story Worst-Case Audit Review of Methodology The Auditor s Approach Reviewed Base Year + 5 years expenses (every invoice) Disputed rsf calculation & pro rata share Found the Landlord s inconsistencies & mistakes Disallowed (whatever that means) numerous expenses with constant references to GAAP and asserted that: The Base Year concept requires the level of service to be consistent from year to year (an invalid concept) Result: The Auditor proposed a revised Base Year and allowable expenses which were so low that the tenant would have only paid escalations in 1 year out of 5. 40

Comparison of Landlord vs Auditor Expenses $6.50 $6.00 per Landlord $5.50 per Auditor Auditor's Base $5.00 $4.50 1 2 3 4 5 6 Year 41 Operating Expenses - $'s PSF

A War Story Worst-Case Audit Dispute Resolution Both parties had flawed methodology Set the stage for settlement Negotiated credit of $50,000 vs. Auditor s claim of $186,000 (27% of the claim*) * Wait - remember the 33% fee? 42

VI. How Can HBA Improve Escalations? Move beyond GAAP Promote Standards to Eliminate Billing Errors

How Can HBA Improve Escalations? Let s agree that GAAP is not enough. Promote & Define industry-wide, standardized methodology to protect your clients, whether they are Tenants or Landlords But especially if you represent Tenants 44

A Simple Solution Modify future Operating Expense clauses to require: (a) the calculation of operating expenses and escalations in accordance with GAAP and methodology endorsed by BOMA International, as periodically revised, or (b) add the following statement (and do me a big favor): Lessor agrees to use as a guideline The Escalation Handbook for Office Buildings published by BOMA International, as periodically revised, or (c) Peg it to some other meaningful Standard that applies 45

Questions & Answers www.escalationadvisors.com AOE is a cloud based software package that automates the escalation billing processes established in our Handbook. Endorsed by BOMA International. Accurate Automated Affordable The Escalation Handbook for Office Buildings is a comprehensive, easy-to-read guide covering escalation theory & practices, and establishes industry-standard methodology used by thousands of owners & managers. Published by BOMA International since 1991 William H, Brownfield, CRE, CCIM Bill@wbrownfield.com 713-907-6497