In most commercial leases, the tenant pays rent for the space and also pays a share of the cost of operating the property. Those costs are called operating expenses, common area maintenance (CAM), or, in retail, CAM, taxes and insurance. The mechanism for charging them is straightforward in principle and a frequent source of confusion in practice. This article explains how it works from the manager's side of the ledger.
The two kinds of leases
In a gross or full-service lease, common in office buildings, the rent includes operating expenses for a base year, and the tenant pays its share of any increase in expenses over that base in later years. In a net lease, common in retail and industrial property, the tenant pays base rent plus its share of some or all operating expenses from the first year. A "triple net" lease passes through taxes, insurance and maintenance. Many leases fall somewhere in between, and the lease language controls, not the label.
Pro-rata share
Each tenant's share is usually its rentable square footage divided by the rentable square footage of the property, expressed as a percentage. Leases differ on what counts in the denominator: the whole building, only the leased portion, or a figure adjusted for anchor tenants who pay their own costs directly. The lease should state the percentage or the method, and the manager should be able to show how it was calculated.
Estimates
At the start of each year, the manager prepares an operating budget and sends each tenant an estimate of its share of expenses for the coming year, billed in monthly installments along with rent. The estimate is a forecast. A good one is close to actual; a lazy one is last year's number carried forward.
The reconciliation
After the year closes, the manager totals the actual operating expenses by category, applies any exclusions, caps or gross-ups required by each lease, calculates each tenant's share, and compares it with what the tenant paid in estimates. If the tenant paid too little, a reconciliation invoice is sent. If the tenant paid too much, the overpayment is credited or refunded. Most leases require the reconciliation within a stated period after year-end, often 90 to 180 days, and a well-run property delivers it on time.
What a reconciliation statement should show
A tenant should receive a statement that lists each expense category with the property total, the tenant's pro-rata share, the estimates paid, and the balance due or credit. It should state the denominator used. The supporting invoices and the general ledger detail should be available for review on request. A manager who cannot or will not produce the backup is a manager whose numbers should be questioned.
Base years and expense stops
In a base-year lease, the tenant pays increases over the expenses of a specified year. If the base year was a year of unusually low expenses, or if the building was partly empty that year, the tenant's exposure to increases is larger than it looks. An expense stop works similarly but fixes a dollar amount per square foot above which the tenant pays. Tenants negotiating a base-year lease should ask what the base-year expenses were and whether they were grossed up.
Gross-ups
When a building is not fully occupied, variable expenses such as janitorial and utilities are lower than they would be at full occupancy. A gross-up clause allows the landlord to calculate those variable expenses as if the building were, for example, 95 percent occupied, so that tenants pay the share they would pay in a full building rather than bearing the cost of vacant space. Gross-ups are legitimate when applied consistently to the base year and to subsequent years and when limited to expenses that actually vary with occupancy.
Caps
Many tenants negotiate a cap on annual increases in controllable expenses, often 3 to 5 percent, cumulative or non-cumulative. Taxes, insurance, utilities and snow removal are usually excluded from the cap because the landlord does not control them. Caps need to be tracked lease by lease, and the reconciliation should show how the cap was applied.
Common exclusions
Leases commonly exclude from operating expenses the landlord's capital expenditures (sometimes allowing amortized capital costs that reduce operating expenses or are required by new laws), leasing commissions, tenant improvement costs, debt service, ground rent, costs reimbursed by insurance or by other tenants, and the landlord's general overhead beyond a stated management fee. The management fee itself is usually capped at a percentage of gross receipts. A tenant reviewing a reconciliation should check that excluded items are not buried in categories such as "repairs" or "administrative."
Audit rights
Most leases give the tenant a right to audit the landlord's books for a limited period after receiving the reconciliation, frequently 60 to 180 days, after which the statement is deemed accepted. Tenants should calendar that window. Landlords who keep clean records welcome audits because the audit confirms the numbers.
Why it matters to the owner
Reconciliations done late, inaccurately or without backup cost the owner twice: once in disputes and write-offs, and again in tenant relationships at renewal time. Reconciliations done on time, with a statement a tenant can understand and backup a tenant can see, recover the owner's costs fully and build the trust that makes renewals easier. At Leasebrook, operating expense reconciliations are a deliverable with a date, and the backup is available to any tenant who asks.