Whether you intend to buy a piece of commercial property and become a landlord or lease a commercial space for your own business, it's very important to understand commercial real estate operating expenses, since they impact both costs for the tenant and net operating income for the landlord.
Operating expenses (opex) are the out-of-pocket costs for running a space, maintaining it, and keeping it legal. They are part of the overhead, just as much as the mortgage. While opex can be a profit engine for a smart landlord who's well versed in minimizing expenses and negotiating favorable contracts, the same expenses can also be crippling to a landlord who doesn't understand how to calculate them or structure them into a contract.
What's included in opex?
The operating expenses for an office or retail-office building are different from the expenses for a multifamily building, in a few very significant ways. Elementally, many of the costs that are passed to unit owners or to the HOA in a multifamily building are shared between lease-holders and landlord in a commercial property. These include:
- Property taxes
- Property insurance
- Management/administration fees
- Common area maintenance (CAM), not including capital improvements
- Utilities, such as HVAC and electricity
- Contracted services, such as janitorial and security
- Supply costs
What's not included in opex?
A few major costs are not included in opex, although it's important to note that they still might end up being a landlord's responsibility -- just calculated and negotiated separately. These include:
- Advertising and marketing costs, which are the responsibility of the landlord or management company.
- Fees associated with refinancing the property.
- Consultant fees and market study fees.
- Tenant improvements, which are negotiated individually with each tenant and are not always the landlord's responsibility to pay.
- Capital improvements/structural repairs. These fall under common area maintenance, but in their own category typically requiring prior approval from tenants, since they can be major additional expenses. This line item is one of the most contentious between landlords and tenants.
How do you calculate operating expenses?
Operating costs are calculated per square foot of rentable space. The included operating expenses listed above all account for part of the overall cost, which is then divided per square foot of rentable space and passed to the tenant -- either as a pro rata share on top of base rent or included in their gross rent. Note the tenant must pay opex not just for their office space square footage but for the rentable space, which also includes a percentage of shared space in the building.
Opex in a commercial lease is typically structured to increase year over year in proportion to the increase in overhead to run the building. If the first year is calculated as the "base year," the second year's opex increases should be a pro rata share of the increase the building faced -- based on factors such as increased property taxes and higher insurance rates.
Operating expenses in relation to net operating income
The formula used to determine net operating income is to deduct opex from gross operating income. Thus, the two are usually mentioned in the same sentence, and any landlord looking to maximize profits must always be mindful of minimizing operating expenses – or passing them along to tenants.
When shopping for commercial properties in a certain neighborhood, one important formula to evaluate by is the operating expense ratio (OER): operating expenses (not including depreciation) divided by gross operating income. A low OER is better, as it indicates minimized expenses and higher profit margins.
Who pays commercial real estate operating expenses?
The tenants of a building generally split the financial burden of operating expenses, paying only the percentage that corresponds with the rentable square footage on their lease. The landlord is responsible for the opex of vacant space. This is why it's so important to keep as much of the building rented out as possible.
The way that opex payment is structured depends on the kind of lease a tenant has, as well as any specifications tenant and landlord agree to in the contract:
- Triple net leases cover base rent only, and opex is assessed pro rata on top of the base rent.
- Full-service gross lease structure includes the opex cost in the base rent.
- Modified gross rent has different inclusions but typically includes many operating expenses in the base rent.
When tenants try to negotiate
A savvy business owner considering becoming a tenant will read the operating expense clause in their lease very carefully and will often come back with items they wish to exclude or limit. They might request that the lease specify, for example:
- Management fees do not include any commissions that a property manager makes on new rentals. Those should fall under marketing/advertising.
- A lower or higher "expense stop." (We'll cover this in more detail below.)
- Utilities need to be measured/metered, not automatically assessed.
- Expenses for major purchases in the utility/CAM categories need to fall under capital improvements and thereby require prior approval from the tenant, not fall under opex where costs get passed along automatically.
Or any number of other things. Tenants who are assertive negotiators will commonly ask for certain limitations and built-in safety parameters to ensure their operating expenses don't escalate beyond a reasonable amount. These include:
In a gross lease, this is the maximum annual threshold for operating expenses that landlords are responsible to pay. Even though gross leases include operating expenses, expense stops put a limit on what the landlord will have to pay. A tenant in a gross lease might ask for a higher expense stop.
The expense stop is also used as a numeric reference point on a lease for reasonable expenses in the first year of a lease. A tenant in a net lease might ask for a lower expense stop.
Operating expense cap
A cap on annual operating expenses charged to a tenant, or a cap on opex increases. This cap particularly can be requested for common area maintenance (CAM) fees, since landlords have the responsibility to hire vendors and source supplies that are billed under CAM fees.
As a tenant, how should you negotiate?
Be sharp-eyed and meticulous in your due diligence. It's good to question landlords and ask for more specific contract language, but before you accuse them of double-dipping or using language that's too vague, make sure you have read and comprehended each clause of the lease. Have a real estate attorney go over it as well. If you're asking for a cap on annual opex, make sure it's reasonable and allows for costs the landlord has no control over, such as tax increases.
Operating expenses are just as significant as rent
It is crucial to know the operating expenses of a building in order to accurately calculate its income potential. No matter what the lease structure may be, operating expenses account for a significant portion of what tenants and landlords worry about the most: the costs incurred as part of doing business.
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