Wednesday, November 22, 2006

Hidden Costs In Commercial Leases In NYC

November 21, 2006

Dear Friends & Clients:


Happy Holiday! Last month's email on commercial lease negotiations was so popular that readers asked for another email on commercial leases.

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Hidden costs in office leases are expenses that a landlord should be paying which are passed along to tenants. If the tenant pays these costs the result is that the landlord is making a profit instead of merely being made whole. Careful negotiation by a tenant can result in significant savings to "additional rent" items and minimize the possibility of the tenant receiving a surprise bill from the landlord during the lease term. Some issues to look for include:

1. Additional Rent clauses which are used to have the tenant pay for increases in real estate taxes and operating expenses. The tenant's proportionate share should from a tenant's perspective be the ratio between the square footage of the space the tenant occupies and the total square footage of the building. Some leases provide that this calculation be based on the rented or occupied space and not the total building area. If the landlord insists on using a calculation based on occupied square footage as opposed to total building space, the tenant should attempt to negotiate an agreed upon percentage to be used to determine the tenant's proportionate share of space.

2. Base Year, which is used to calculate when the tenant will have to pay the landlord additional building expenses and taxes. The Base Year for taxes and operating expenses are both subject to negotiation. From the tenant's perspective, these amounts should be as high as possible. Real estate taxes may be subject to adjustment years after the Base Year and a reduction in taxes could result in a windfall for the landlord that is unfair to the tenant. One possible strategy for a tenant is to have the base year consist of an average of 2 years.

3. Porter Rates are the most favorable way to calculate an increase in operating expenses from the perspective of the landlord. General operating expenses are day-to-day expenses of running the building, which are subject to increase. The tenant usually pays its proportionate share of the increases in operation expenses over the base amount. The Porter's Wage is calculated as the difference between the Porter Wage Rate as determined by the collective bargaining agreement and the wage rate determined by the collective bargaining agreement for the escalation year. Porter wages allow a landlord to make a profit on what should be a reimbursed expense.

Less onerous is an increase based on the Consumer Price Index. If the CPI is used some expenses should be carved out of this formula such as interest or penalties on taxes that the landlord is required to pay or the payment of interest or principal on the landlord's debt service.

4. Capital improvements enhance the building and allow the landlord to charge more rent, so the landlord should pay for these improvements, though it's less clear who should be responsible for payment when the improvement is required by law or obsolescence. For example, at what point should a long term tenant in the last year of a lease pay for an improvement with a useful life of 15 years past the lease term? The tenant should not pay more than its proportional share (in the example, 1/15th of the cost of the improvement in the last year of a 15 year lease).

Any person with questions regarding commercial lease issues should contact Jim Shenwick.

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