Understanding a Landlord’s Ability to Increase the Tenant’s Share of Operating Expenses

In a commercial lease setting, in addition to the monthly rental payment, the tenant is often obligated under the lease agreement to reimburse the landlord for the tenant’s “Pro Rata Share” of certain “Operating Expenses” (sometimes called Common Area Maintenance expenses or CAM), which share is commonly determined by comparing the rentable square footage of the tenant’s leased space to the overall rentable square footage in the entire building or shopping center.

What are “Operating Expenses”?

Operating Expenses regularly include, but are not limited to, real property taxes, insurance maintained by the landlord, utilities, and other expenses relating to the maintenance, repair and operation of the building or shopping center, such as management and administrative fees, wages of maintenance personnel, costs relating to signage, landscaping, sidewalks and parking areas, refuse and trash removal, window washing, and janitorial and security services.  The lease agreement will sometimes also detail which items are not deemed Operating Expenses subject to reimbursement by the tenant, such as depreciation of the building, the landlord’s loan payments to its lender, brokerage commissions, legal fees incurred by the landlord in disputes with other tenants in the building, and expenses which would otherwise be deemed an Operating Expense but which are paid to the landlord by an insurance company, a condemning authority, or another tenant.

Is negotiation possible?

Depending on the negotiating leverage and market conditions, an experienced attorney for the tenant may be able to negotiate certain controls on the landlord’s ability to increase the tenant’s share of Operating Expenses.  One such control is placing a cap on the annual increase of “Controllable Operating Expenses” which are typically defined as all Operating Expenses other than items which are beyond the landlord’s control, such as property taxes, insurance, utilities, and extraordinary costs of maintaining, repairing or operating the building occasioned by strikes, lock-outs, embargoes, unavailability of labor or materials, acts of God, or government restrictions.  If such a cap exists, it is commonly in the 4% to 6% range.

The Importance of a Reconciliation Statement

Another important control is to require the landlord to provide a reconciliation statement within a time certain (typically between 60-90 days) after the end of each calendar year.  Such reconciliation will compare the amount of Operating Expense funds collected from the tenant to the actual Operating Expenses incurred by the landlord.  If the reconciliation shows an over-payment by the tenant, any surplus is typically credited to the tenant’s next monthly rent payment, and if the reconciliation shows an underpayment by the tenant, the tenant is typically required to pay that deficiency to the landlord within a time certain (usually 30 days).

Finally, yet another important check and balance on the landlord’s ability to increase the Tenant’s share of the Operating Expenses is to provide the tenant with the right to conduct an audit of the landlord’s books and records relating to Operating Expenses to verify the accuracy of the landlord’s determination of the tenant’s Pro Rata Share.  If the lease provides the tenant with such a right, it typically must be exercised within a defined period (usually 30 – 60 days) after the tenant receives the reconciliation statement.  In some cases, the lease may go so far as to require the landlord to pay for the tenant’s audit if it reveals an overcharge of a certain amount (often 5% or more).  However, there may be a risk in performing such an audit if the lease obligates the tenant to pay additional funds to the landlord if the audit reveals a greater shortfall than shown in the landlord’s reconciliation statement.

Seeking Assistance

As the tenant’s share of Operating Expenses can represent a significant sum over the life of the lease, it is important that the tenant have an experienced adviser who can help navigate this complex area and build in controls on the landlord’s ability to increase such expenses.

If you have questions regarding commercial leasing matters, please contact one of the attorneys in MPBA’s Real Estate Department.