I was honored to be asked to write a blog about one of my favorite and least favorite subjects that I had to deal with in my career. Operating expenses! Operating expenses are rent. Yes, there it is. What more can I say?
I can say plenty actually. There is so much to talk about on this subject and when I was asked by Andrew Bermudez to write this blog as a guest blogger, I was challenged. After 30 years in the industry (yes, that is 3 decades) and way too many operating expense calculations performed, I can tell you that operating expenses are about details and mastering those details so you are really collecting the full amount of rent due.
Rent is rent and the total you spend as the occupant is made up of whatever the market will bear in total rent! Yes, that is how markets work. Now, once you determine what the market will bear, the Landlord also has to put the key in the door of the building every morning and turn on the lights and do the landscaping and throw out the trash. All of that represents what it costs to occupy the building. So no matter how you look at it, the cost to occupy the building is fairly fixed.
It is generally made up of these basic categories (Note these are big picture categories and the sub categories can get very detailed):
- Repairs & Maintenance
- Contract Services (Janitorial, window washing, landscaping, scavenger)
- Real Estate Taxes
I do not know who invented this idea, but I sure wish there was a better way. When you rent anything else in the universe there is not this much red tape and number crunching and cya, than with dealing with a commercial lease and collecting the rent. If I rent an apartment, I pay the rent and that is my deal. When I rent an office or a retail site, I have all of this insane legal wording to insure the deal is saying what I think it is saying and intense calculations and words to hang on with every single lease. God only knows how the last broker or attorney may have altered the lease. (Another future subject: lease standards!)
But because this is such a huge topic, I thought it best not to talk about mechanics, but more about the theory. Why do I say operating expense are rent? Well because it is rent. I do not care how you spin it, twist it or what you call it, modified gross, full gross, full service gross, net, triple net, double net, NNN, whatever, it does not matter. What does matter is that it costs the tenant X to occupy the space and that X, in essence, includes what it costs to run the property.
That means as the tenant I am paying one simple number right? Wrong. You are still paying your proportionate share of that building’s operating expenses. It can be combined or rolled up or whatever, but I can bet you that whatever you are paying is very close to another building in that same market and same property size, who may be paying a net or a gross rent. The only difference is how the rent is presented or how transparent it is. For the sophisticated tenants with CAM Departments, this is no big deal, but for your average joe tenant, this stuff is mumbo jumbo, I do not care what anybody thinks. The average joe tenant has absolutely, no time to learn all of the variations known to mankind and all of the ways these deals are done. There are a multitude of triggers that make the charging of operating expense tons of work. What I am referring to is all of the market driven terminology and methodologies that have been concocted to control excessively escalating or decreasing operating expenses.
- Base Years
- Grossing up
- Cumulative caps
- Non-cumulative caps
- CPI increases
- Flat increases
To name a few.
But the basic reason for all of the various twists and turns that circle around operating expense, like stops or base years, etc. are just basically hedges against inflation and protection for both parties so the original estimates quoted do not escalate or decrease to insane levels. But it is again, just the tenant paying its’ fair or proportionate share of what it costs to run the building.
So as the building owner you try very hard to control what it costs to run the building as you have a product you are selling, which is square feet. The cost of running the building is just like manufacturing a product. When you watch Shark Tank and the sharks ask what does it cost you to make the product, it is no different for a building owner. The operating costs of that building is the product cost of that square foot. So the building owner is desperately trying to at least cover its costs of operating the building, hence the term operating costs plus the building owner has to pay other costs that are NOT part of operating costs, like mortgage, marketing and advertising, professional fees, leasing commissions, tenant improvements, and any other cost of owning that building.
So if you are leasing square feet you are balancing what the market will pay (total occupancy cost) with what it costs you to operate your building plus what it costs you to own your building and you pray that the market demand allows you to ask a rent level that can cover those expenses in totality. I really mean pray because it is fickle and the cycle changes. You do not want to get caught in a -0- net rent cycle. That can be rather ugly. Remember, -0- net rent means I am only paying operating expenses so the building owner still has to pay the mortgage and other owner expenses. Yes, this can happen.
Remember too, that, as the building owner you still have to pay for every square foot of operating expense that is not leased AND you need to keep the costs down so you don’t get killed if there is any vacancy.
Items not included in operating expenses:
- Leasing Commissions
- Tenant Improvements
- Capital Improvements
I also want to stress that the reason for so many variations is the fact that none of us control insurance, utilities or real estate taxes. Now, we can control them to some degree, but not as much as we can other things that are like purchasing flowers for the lobby or cleaning the windows 2x per year not 3x per year. Real estate taxes, insurance and utilities cost money to manage and control and you cannot stop those services. The building owner hires real estate tax attorneys, for instance to keep taxes down, the building owner buys new HVAC equipment to keep utilities down or buys new light bulbs or fixtures to keep electricity down. You cannot just sit and do nothing to keep those categories down as they cost you to invest to keep them controlled. Insurance is very tricky. Sometimes you can do something to keep insurance rates down, but in reality insurance can be driven by weather or tragedies that none of us control.
My word of advice to anyone, whether you are a tenant, broker or building manager, is to master those leases you are involved with and learn it so it becomes second-nature to you. Understand the wording, the clauses and how the calculations are done. If you are a tenant, ask questions.
I hope this brief overview gives you more of an insight into what the term operating expenses mean to both sides of the table of the deal and I also hope you believe me when I say details matter with operating expenses.
This is a guest post by Linda Day Harrison, Founder of TheBrokerList.
About the Author
Linda Day Harrison founded theBrokerList.com in an effort to create efficiency and streamlined operations for the commercial real estate industry, property and facility management, leasing and brokerage. Linda contributes more than 25 years of professional commercial real estate experience gained in suburban and central business district office and mixed-use buildings, condominium conversion and management, commercial and residential leasing, commercial and residential management, re-positioning and marketing for the disposition of commercial properties. Follow me on Twitter @dayharrison or connect with me on Linkedin or check me out on tBL Linda Day Harrison, CPM, CCIM.