Operating Expenses, CAM and Real Estate Taxes Explained

A commercial building costs money to run whether or not it is full. Someone has to clean the lobby, staff the front desk, maintain the elevators, insure the structure and pay the property tax bill. A pass-through is the lease mechanism that moves those costs from the landlord to the tenants.

The vocabulary varies by building type and by landlord. Operating expenses, often shortened to opex, is the usual term in office buildings. Common area maintenance, or CAM, is more common in retail and industrial leases and sometimes refers only to the shared areas. Real estate taxes are frequently listed as a separate category, as is insurance. Together they are sometimes called additional rent, because the lease treats them as rent you owe on top of base rent.

The label matters less than the definition. Every lease defines its own list of what counts, and that definition, not the label, decides what you pay.

A typical definition of operating expenses covers the recurring cost of operating, maintaining and repairing the building. Common items include:

• Janitorial service, trash removal and window cleaning
• Utilities for common areas, and sometimes for tenant spaces when they are not separately metered
• Repairs and maintenance of building systems such as elevators, heating and cooling, plumbing and life safety
• Security, front desk and engineering staff
• Property management fees
• Building insurance premiums
• Landscaping, snow removal and parking area upkeep
• Amenity spaces such as a fitness center, conference center or tenant lounge

Landlord lease forms tend to define operating expenses broadly. Tenants commonly ask to exclude costs that have more to do with owning or leasing the building than with running it. Examples include the landlord's mortgage payments, leasing commissions and build-out costs for other tenants, costs reimbursed by insurance, and major capital replacements. Capital items are a frequent point of negotiation. A new roof or a replaced chiller benefits the building for many years, so tenants often ask that such costs be excluded or spread over the useful life of the item rather than billed in a single year.

Have your attorney review the definition and the exclusions. A short list of exclusions in a proposal can turn into pages in the lease.

Your portion of the building's costs is your pro rata share, sometimes called your proportionate share. It is your rentable square footage divided by the rentable square footage of the building. If the building is remeasured, or the denominator is defined as leased area rather than total area, your share changes, so check how the lease defines both numbers.

How that share is applied depends on the lease structure:

• In a net lease, you pay your share of all operating expenses and taxes from the first day, in addition to base rent.
• In a gross or full-service lease with a base year, the rent already includes the costs of a starting year. You pay your share of any increase above that year's level.
• In a modified gross lease, some categories are included in rent and others are passed through. The lease spells out which.

Base year leases raise one technical point worth understanding. If the building is partly empty during your base year, costs that vary with occupancy, such as cleaning, will be unusually low, and every later year will look like an increase. A gross-up clause adjusts variable costs as if the building were fully or nearly fully occupied, so that the base year and later years are compared fairly. Tenants should confirm that the base year is grossed up on the same terms as later years.

Landlords do not know the year's actual costs in advance, so billing works in two steps.

1. Before or early in the year, the landlord sets a budget and gives each tenant an estimate of its share.
2. You pay that estimate in equal monthly installments along with base rent.
3. After the year ends, the landlord totals the actual costs and prepares a reconciliation statement.
4. If you paid less than your actual share, you receive a bill for the difference. If you paid more, you receive a credit or refund.
5. The landlord resets the monthly estimate for the new year based on the latest figures.

The reconciliation is the step that surprises new tenants, because a true-up bill can arrive months after the year it relates to, and it can arrive after you have moved out. Budget for it. Read the statement when it comes, compare it with the prior year and ask the property manager to explain any category that moved sharply. Leases often limit how long you have to question a statement, and many give tenants a right to review the landlord's records. The scope of that right is negotiated.

Base rent follows a schedule you can read in the lease. Pass-throughs do not, and several things can move them.

• Property tax reassessment. Taxes follow the assessed value of the building and local tax rates. A reassessment, including one that follows a sale of the building at a higher price, can raise the tax bill, and tenants share in it.
• Occupancy. Some costs rise as a building fills. Without a gross-up clause, a tenant in a lease-up building can see steep increases.
• Capital projects. Lobby renovations, new amenities and system replacements may be passed through in whole or in part, depending on the lease.
• Insurance, labor and utility markets. Premiums, wages for building staff and energy prices are outside any one landlord's control.
• Management decisions. A new owner may run the building differently, with different staffing, vendors and service levels.

In a multi-tenant building you cannot control these costs, but you can limit your exposure to them when the lease is negotiated. Typical protections include exclusions from the definition, a ceiling on how fast certain costs can rise each year, protection against a tax increase triggered by a sale, and a clear right to review the landlord's books.

Two buildings with the same base rent can have very different pass-throughs, so ask for the numbers and the rules early.

• ✓What are the current estimated operating expenses and real estate taxes for the building, stated on the same basis as the rent?
• ✓How have those figures changed over the last several years?
• ✓Is the lease net, gross with a base year or modified gross, and which year is the base year?
• ✓Are variable expenses grossed up, and is the base year treated the same way?
• ✓Which capital costs can be passed through, and how are they spread over time?
• ✓Is the building for sale or recently sold, and how are tax increases after a sale handled?
• ✓Is electricity for our suite included, submetered or billed separately?
• ✓What right do we have to review the landlord's records, and how long do we have to dispute a statement?

When we compare buildings for a client, we request this history from each landlord and build it into the cost comparison, because a low rent paired with high or fast-rising pass-throughs is not a low-cost building.