The ft.² Report

DEMYSTIFYING OPERATING EXPENSE PASSTHROUGHS

Office tenant clients frequently ask us what are operating expenses? Admittedly, this is one of the more confusing aspects of a commercial lease and if a tenant is not careful, it can be a costly item. The best way to explain operating expense passthroughs is to provide an example. But first, it is important to know a few key terms:

Full Service Rent vs NNN Rent - Full Service includes normal office utilities, janitorial service, building maintenance and management as well as property taxes while NNN invoices tenants separately for utilities, taxes/insurance and operating expenses.

Rentable Square Feet vs. Useable Square Feet – Rentable Square Feet (RSF) is the square footage that a tenant pays rent on while Useable Square Feet (USF) is the actual size a tenant is using. The difference is that RSF includes a portion of the common areas used by all tenants tacked on to the USF. Otherwise, lobbies and corridors would be used and maintained but lose money for the owner. This additional percentage is called a “load factor” and ranges between 10% and 18% typically. (Ex: 10,000 USF x 15% load factor = 11,500 RSF)

Operating Expenses and Passthroughs - Operating expenses are necessary to run a building including electricity, water and sewer, trash, exterior building maintenance, gas, landscaping, window cleaning, janitorial services, security, property taxes and property management. Passthroughs represent increases above the operating expenses incurred during the Base Year of a Full Service Lease.

Base Year – Can either be the first 12 months of a lease term or calculated on a calendar year. The calendar year method is most common. If a lease commences in the 4th quarter, the Base Year is usually set for the next full year. (Ex: Lease commences 11/1/11, Base Year will be 2012. Lease commences 4/1/11, Base Year will be 2011) 

Okay, so now that you are more thoroughly confused, let’s break all of this information down into an example that will make it easier to understand the calculation of passthroughs.

• The beautiful Jones Tower (because Smith Center is still under construction) is a Class A office highrise with 491,528 RSF.  
• ImDabomb Company occupies 10,000 RSF in Jones Tower with a lease that commenced March 1, 2009 and is paying $20.00/RSF Full Service.
• They have a Base Year of 2009.
• In 2009, operating expenses were $10.04/RSF.  This is the Base for ImDabomb Co.
• Jones Tower has 2010 Operating Expenses  of $10.34/RSF.
• Jones Tower has 2011 Estimated Operating Expenses of $10.73/RSF.

During 2010, ImDabomb would have paid its rent plus the difference between the 2010 budget and the 2009 Base ($10.34 – $10.04 = $0.30).  This amount is then multiplied by the total RSF under lease by ImDabomb and divided up over 12 months ($0.30 x 10,000 RSF = $3,000.00/12 = $250.00 per month additional cost).

During 2011, ImDabomb would have paid its rent plus the difference between the 2011 budget and the 2009 Base ($10.73 – $10.04 = $0.69).  This amount is then multiplied by the total RSF under lease by ImDabomb and divided up over 12 months ($0.69 x 10,000 RSF = $6,900.00/12 = $575.00 per month additional cost).

Every year, the new expenses are calculated against that Base Year figure, so the numbers can really add up  particularly for larger tenants.  If, however, the operating expenses come in below the estimates for the newest year, the tenant will be issued a credit. 

It is important to “reset” your Base Year in the event of a lease renewal or extension. Otherwise, a tenant will continue to see increasing passthrough costs as the gap over the Base Year figure grows.  Much of the increase in expenses is due to things such as city tax changes, expiration of tax credits, building improvements not considered capital costs such as paving a parking lot or painting the exterior, and increases in utility charges.

For a more detailed report on Operating Expenses, please email me at kristin.hammond(at)pacific-re(dot)com.

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