Operating expenses are the costs of operating and maintaining a property and may include property taxes, insurance, utilities, maintenance, repairs, and management fees depending on the type of building and lease structure. For an occupier (tenant) in commercial real estate, these expenses are typically passed through either by a higher rent or separately in addition to base rent.
For occupiers, it’s crucial to understand the specifics of what is included in the operating expenses of their lease agreement. Different definitions of operating expenses can significantly impact the overall financial obligations.
Why Are Operating Expenses Important?
Understanding operating expenses is crucial because they can significantly impact the cost of leasing a commercial space. Occupiers often focus on the base rent first because it is a more significant, tangible expense. However, while operating expenses will usually start as a smaller expense, they can increase quickly. Contrary to base rent, these expenses can move dramatically during a lease term because these costs are inflationary and subject to market pricing year over year.
It’s essential to have a qualified broker and attorney review the lease and mitigate these risks to operating expenses by including terms such as operating expense caps, operating expense exclusions, and audit rights. A qualified “tenant rep” broker, such as Park Realty, would advocate and negotiate operating expenses beforehand in the Letter of Intent (LOI). By addressing these elements early in the negotiation process, occupiers will reduce the time and money spent on legal fees and protect themselves from hidden costs through the lease term.
Controllable & Non-Controllable Expenses
Some expenses are labeled “uncontrollable” expenses, such as taxes, utilities, and insurance. Landlords don’t cap these expenses because they are outside the landlord’s control. Other expenses are “controllable” expenses, such as maintenance or security contracts, management fees, janitorial costs, and improvements made to the property. These items can and should be negotiated and subject to caps because the landlord controls them but doesn’t pay the expenses and passes them to the occupier.
Operating Expenses By Lease Type
The operating expenses that occupiers pay typically vary depending on the type of commercial lease. Each lease type will have different rent structures and implications for operating expenses.
Full Service (“Gross”) Lease
In gross leases, landlords lump all operating expenses into the rental rate for one “gross” rate. This is the simplest form of lease where the rate includes all building operating costs, such as property taxes, insurance, maintenance, utilities, and janitorial services into one payment. The tenant pays a single, all-inclusive rent amount that covers the base rent and operating costs.
However, occupiers should still be careful to read their lease. In most gross leases, this gross rate only includes the operating expenses for the first year or “base” year and does not cover increases over that amount. In subsequent years, the operating costs will likely increase, and an occupier will pay for those increases.
While a gross lease may simplify the rent structure, it is still important to understand what is covered and not covered in the base rate. Having operating expense caps in place to limit cost increases can be very important.
Triple Net Lease (NNN or “Net” Lease)
The most common type of lease today is the triple net lease. In a triple net lease, all operating expenses are separate from the base rent, and the occupier is responsible for paying a portion of the property taxes, insurance, and maintenance (the three “net” expenses). Simply put, this is the counterpart to the gross lease we spoke about earlier. All operating expenses are separated from the base rate so that the landlord knows their income on the lease.
Modified Gross Lease
A modified gross lease is a hybrid between a gross lease and net lease. Often found in industrial and single tenant or lower quality office buildings, it requires the tenant to pay the base rent plus a portion of certain operating expenses, such as utilities or maintenance, while the landlord covers the remaining costs. Real estate professionals may also refer to a modified gross lease as an industrial gross lease used specifically for industrial properties. Utilities are typically separated in such instances because each occupier has different power needs.
This type of lease offers more predictability than a triple net lease but less than a full-service gross lease. Similar to a gross lease, occupants should be aware of any operating expenses owed over a base year.
Operating Expenses By Building Type
Operating expenses can vary significantly depending on the property type—office, retail, or industrial. The key differences lie in the nature and extent of the services provided and maintained by the landlord.
Below is a list of the typical inclusions and exclusions with each:
Office
Office properties often have extensive common areas require more day to day management. Examples include janitorial cleaning and on-site management maintaining conference rooms or gyms. As a result, occupiers can expect to see these costs come up in their operating expenses as something they are reimbursing the owner for.
Retail
Retail properties require less property management and focus heavily on CAM charges and promoting tenant traffic. Occupiers have very different utility needs and typically have to pay for their own separately metered utilities.
Industrial
In contrast, industrial properties typically have lower maintenance and fewer common areas, focusing on essential structural and exterior maintenance. Typically the landlord pays for non-controllable expenses and repairing structural defects. As a result, occupiers typically manage and take on the responsibility of maintaining the systems. All utilities can be separately metered if the property is an individual building, however many have separately metered electricity at a minimum.
