Operating Expense Caps and Audit Rights

In most office leases you pay base rent plus a share of what it costs to run the building: staffing, cleaning, repairs, utilities for common areas, insurance, management and real estate taxes. Depending on the lease structure you pay your full share of those costs, or your share of increases over a base year.

Either way, the amount is variable and the landlord controls most of the decisions that drive it. The landlord chooses vendors, sets staffing, decides when to repair and when to replace, and prepares the statement that tells you what you owe. A lease with no limits asks you to accept whatever that statement says for the whole term.

Three tools manage the risk: a cap on increases, a list of costs that may not be passed through at all, and the right to audit. They work as a set. A cap on a number that includes costs it should not include protects much less than it appears to.

Landlords will rarely cap all operating expenses, because some costs are outside their control. The negotiation is over where the line sits.

• Typically treated as uncontrollable: real estate taxes, insurance premiums and utilities. Landlords often add snow removal, costs of complying with new laws, and union labor under collective bargaining agreements.
• Typically treated as controllable: management fees, janitorial and maintenance contracts, administrative costs, landscaping, routine repairs, non-union payroll and most other services the landlord buys or staffs at its discretion.

The form definition of "uncontrollable" tends to grow with each draft. Every item moved to that side is an item with no cap. Ask for controllable expenses to be defined as everything except a short, specific list, instead of defining the cap as applying only to a short list. Security costs, management fees and repair contracts are common points of disagreement.

Taxes deserve their own review. A sale or reassessment of the building can change the tax bill sharply, and taxes are almost never capped. Ask your broker and attorney whether protection against a reassessment triggered by a sale is achievable in your market and deal.

Two leases can state the same annual cap and deliver very different results, depending on how unused room under the cap is treated.

• Non-cumulative cap. Each year stands alone. Controllable expenses may rise by no more than the cap over what was actually charged the prior year. If costs rose by less than the cap one year, the landlord does not get to use the difference later. This is the tenant-favorable version.
• Cumulative cap. The landlord may carry forward the unused portion. If actual increases were below the cap for several years, the landlord can pass through a much larger jump in a later year, as long as the total stays within the cap applied across the whole period.
• Compounding. A separate question is whether the cap is measured against the prior year’s actual costs or against a figure that grows by the full cap amount every year regardless of what was actually spent. A cumulative and compounding cap gives the landlord the most room.

The phrase to look for is what the percentage is applied to. "Over the prior year’s actual controllable expenses" and "over the amount that would have been permitted in the prior year" are not the same promise. Ask the landlord to show a worked example of the cap across several years, and have your attorney confirm that the lease language matches the example.

A cap is described in one sentence in the proposal and several in the lease. Settle cumulative or non-cumulative, and what the base is, at the proposal stage.

A cap limits growth. Exclusions limit what is counted in the first place. Tenants commonly ask that operating expenses exclude costs that benefit the landlord’s ownership more than the tenants’ occupancy.

• ✓Are capital expenditures excluded, or limited to defined categories and spread over their useful life?
• ✓Are leasing commissions, tenant improvement costs and marketing costs for other space excluded?
• ✓Are the landlord’s debt service, ground rent and financing costs excluded?
• ✓Are costs reimbursed by insurance, warranties or other tenants excluded?
• ✓Are executive salaries and costs of the landlord’s corporate overhead excluded?
• ✓Is the management fee limited, and are payments to landlord affiliates held to market rates?
• ✓Are fines, penalties and costs caused by the landlord’s own violations excluded?
• ✓Are services provided to other tenants but not to us excluded?

If your lease uses a base year, check how that year is built. A base year set when the building was partly empty or newly reassessed can be artificially low, which makes every later year look like an increase. Two protections address this. A gross-up clause adjusts variable expenses in every year, including the base year, to what they would have been at a stated occupancy level. And where a cap applies, confirm how it interacts with the base year so the first comparison year is not distorted.

Each year the landlord sends a reconciliation statement comparing the estimates you paid with actual costs. An audit right, sometimes called an inspection or review right, lets you check the records behind that statement. Without it, your only option is to ask politely.

The clause is short, but each term in it affects whether the right is usable.

• Deadline to object. Leases set a window after you receive the statement in which to request a review. A short window can pass before a busy finance team has opened the envelope. Ask for more time than the form offers.
• How far back. Ask whether a review can reach prior years, particularly the base year, since an error there repeats every year after.
• Who may audit. Landlords often bar auditors paid on contingency and may require a certified public accountant. Understand the restriction before you agree to it, because it changes what an audit costs you.
• Where and how. Records are usually made available at the landlord’s or manager’s office, on notice, during business hours. Ask for the right to copies.
• Confidentiality. Expect to sign a confidentiality agreement covering the results.
• Remedy. If the review shows an overcharge, the lease should require a prompt refund or credit. Ask that the landlord also pay the cost of the audit when the overcharge exceeds an agreed threshold.
• Disputes. The lease should say how a disagreement between your reviewer and the landlord’s accountant gets resolved.
• Paying meanwhile. You will normally have to keep paying the billed amounts while the review is under way.

Rights that sit in a drawer do nothing. A few habits make them work.

1. Record the audit request deadline on your finance calendar when each reconciliation statement arrives.
2. Compare the statement with the prior year by category, and ask the property manager to explain any line that moved sharply.
3. Check the statement against the lease: your pro rata share, the cap calculation, the gross-up and the exclusions.
4. If the explanation does not hold up, send the written audit request before the deadline.
5. Raise recurring issues when you next negotiate, such as a renewal or expansion, where you have leverage to fix the language.

Tenant Advisory Group negotiates expense caps, exclusions and audit language as part of the economics of each proposal for the technology companies we represent, because a lower rent with open-ended pass-throughs can cost more over the term than a higher rent with firm limits. Have your attorney and CPA review the final language.