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Trickiest lease clause

An operating expense clause lets your landlord recover normal out-of-pocket costs of running a building. That should be all it does. Operating expenses listed in your bill should correspond directly to benefits you gain under the lease, and they ought to meet an objective standard such as GAAP (generally accepted accounting principles), not conventions particular to your landlord.

Insist on a precise and limited definition of the items to be included. Landlords sometimes use the operating expense clause as a profit center. If you approve a catchall clause, which many landlords argue is necessary, it can become a blank check. You may be billed for charges that have little to do with running a building. Ambiguity also increases your risk of litigation.

Exclusions. Certain items should be specifically excluded from operating expenses: electricity that serves tenants' spaces (the landlord recovers this from each tenant individually); executive salaries; consulting fees; market study fees; commissions and advertising costs; initial landscaping costs; structural repairs or replacements; penalties incurred because the landlord fails to pay taxes on time; fees and higher interest charges caused by the landlord's refinancing of the property; money the landlord must pay if it defaults under a lease or other agreement; any legal fees to resolve disputes involving the landlord; any excessive amount the landlord pays a contractor or vendor because of a special relationship.

Capital improvements. Capital expenditures require particular attention when you're negotiating a lease. The operating expense clause should exclude them generally from the operating expenses for which you are billed.

A large organization in New York got a repair bill after its landlord installed a new air-conditioning system. The organization refused to pay, and the case ended up in court. The lease required the landlord to make all structural repairs. The practice was responsible for its share of all other building maintenance and repairs, including repairs to the air-conditioning system. The court reasoned that replacing the system goes beyond traditional notions of repair. This was a capital expenditure that the landlord couldn't pass on to the tenant. While the practice won, it had taken needless risk because its lease didn't make the landlord responsible for capital expenditures.

Even with an exclusion, substantial capital expenditures -- artfully relabeled -- can find their way into your operating expense bill if you're not careful. For instance, a lease may require you to pay for equipment rentals. This is a common technique for converting capital expenditures into expenses that are passed on to the tenant. You should agree to pay for equipment rentals only if they're not a substitute for capital equipment the landlord would otherwise have to buy.

Certain capital improvements, like new, more efficient elevators or a new HVAC system, are supposed to reduce the cost of running the building and thus your portion of operating expenses. Such capital expenditures normally are not included in operating expenses. Landlords often insist, however, that you absorb a portion of the cost. Ask for some demonstration that in fact these capital expenditures will reduce operating expenses. Then if you agree to a lease that allows your landlord to bill you for the annual amortization of these items, make sure your portion is limited to the savings that you realize in a particular year. In other words, your net operating expense should be no higher than it was before the cost-saving installation.

Double dipping. The landlord’s costs of running separate income producing parts of the building should be rolled into operating expenses only after the income is deducted from your operating expenses. This goes for sundry shops, coffee shops, observation decks, and so on. If the building has a garage, your landlord probably charges tenants and the public for parking spaces, but the cost of operating the parking garage may also be included among your operating expenses. If your lease doesn’t specifically exclude this cost, your landlord has a good argument for billing you.

Electricity. For many tenants, electricity is one of the biggest operating expenses. Landlords that want to augment their revenues without quoting a higher rent often use the electricity clause as a profit center, inflating the already substantial cost for this essential service. Don’t let your landlord’s profit unnecessarily increase your utility bills. Typically, leases provide that electricity will be paid for in one of three ways: direct metering, submetering, or rent inclusion.

Direct metering is straightforward and may be the cheapest for you. When the utility directly meters your electricity, you pay the actual charge for what you use. There’s no question of intervening profit for the landlord.

When only one meter in the building connects to the utility, you or your landlord may install a separate meter to measure the electricity you use. Your landlord pays the utility, and you pay the landlord. This method, called submetering, can give you cheaper electricity, provided you know what to ask for. If your landlord can buy electricity at low bulk rates, you should bargain for the benefit of that lower rate. Leases often say the tenant will be billed "in accordance with" a utility’s published rate schedule. This may mean the landlord will charge you the highest rate that would apply to your own consumption and pocket the difference.

If a building has only one meter, your electric charges may simply be lumped in with your rent. This method is the riskiest for tenants. The landlord usually estimates your electricity usage by looking at your office equipment and asking how many hours you use each piece in a typical day or week. Such estimates are inherently less certain than measuring the amount of electricity you use; on one Manhattan block, the basic rate landlords charge for electricity varies more than 30%.

Be wary of such estimates for another reason. They may include a substantial "safety factor" that needlessly increases your costs. For instance, suppose your landlord pays $2.25 per square foot for electricity but adds $2.75 a square foot to your basic rent. A 10% rate increase would raise your charges to $3.02, and your landlord’s profit would grow from 50 cents to 55 cents per square foot. If your office were 10,000 square feet, that extra 5 cents alone would cost you $5,000 over a ten-year lease term. Your landlord’s profit on your electricity bill: $55,000. And that’s assuming no further increases.

Can the landlord cut off your electricity? Leases used throughout the country often allow a landlord to do it on short notice – leaving a tenant to deal directly with a utility. Making your own arrangements for electricity can be expensive and time-consuming. It may require much interior work – like new risers, conduits, and wiring – which, incidentally, your lease may not give you the right to install. Landlords have used such clauses to gain leverage when dealing with unrelated matters.