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Is that a Capital Cost of an Operating Expense?

In a previous post, I wrote about passthrough costs that exist in ‘Net leases’ (most leases in Ottawa). In brief, these are expenses related to the operation of your building passed through to you by your landlord. Operating expenses typically include utilities, maintenance and repair, janitorial services, snow removal / landscaping, etc. and make up your additional rent. In essence, they are expenses that were paid during that year to run and maintain the building.

Another type of expense landlords face are called Capital costs. Capital costs are incurred when acquiring, replacing or completing major repairs to a building and / or the equipment servicing the building. Basically, these are renovations or upgrades to things which create long lasting value such as the building structure / roof or major mechanical systems including the elevators, escalators, heating, ventilation and air conditioning system (HVAC).

 

Why the Distinction is Important

Understanding the distinction between Capital Costs and Operating Expenses is extremely important. Fluctuations in operating expenses, like electricity or property taxes, generally result in invoices / rebates for nominal amounts equivalent to a few cents per sq. ft. of rentable area. However, Capital costs can amount to hundreds of thousands of dollars, and if passed through to tenants, can spike the additional rent dramatically.

 

A Contentious Topic

Landlords are in business to generate profit and increase the value of their buildings, as you or I would if in their shoes. This is done by increasing net (aka base or minimum) rent and passing through as many costs as possible to tenants. Some landlords feel that as a tenant, you are benefiting from renovations and upgrades, so you should pay a portion of these costs.

As a tenant, you likely feel that the net rent you pay should cover the cost of major repairs and replacements of ‘big ticket’ equipment and components of a building. These items are owned by the landlord, not by the tenant. If the improvements provide a benefit to the landlord beyond the term of the lease, they should be at the landlord’s expense.

 

So Who Pays What?

It really comes down to the wording of the lease. That said, many Ottawa landlord’s will follow ‘generally accepted accounting principles’ when addressing Capital Costs. As such, if a cost is incurred to increase the life of a building, or improve its service delivery to a tenant, it is the Landlord’s cost. For example, replacing the building elevators or upgrading the rooftop chillers that cool the building.  When costs are incurred to maintain a building, or the building’s structure, such maintenance costs can be passed through to the tenant via additional rent. For example, repairs to the building roof or building lighting.

When capital expenses are not clearly defined in a lease, a landlord may have more discretion as to what is passed through to a tenant. In these situations, tenants can end up paying for ‘repairs’ that may otherwise be considered capital costs. To make matters worse, capital costs may even be included in the operating expenses.

 

Recommendations

The distinction between Capital Costs and Expenses is complicated. A detailed overview of the issue is far beyond the scope of this post, and better addressed by your accountant or lawyer. However, here are a few recommendations that may help:

1.  Renovations – if renovations are planned for the building, be sure to ask about the timing and how the cost of the renovations will impact the operating expenses;

 

2.  Historical Expenses – ask to review the operating expenses for several prior years to confirm if there have been any dramatic spikes;

 

3.  Legal Review – the language concerning operating expenses, and the definition of Capital Costs in your lease, should be vetted by a lawyer to limit your exposure;

 

4.  Cap escalations – if you have the leverage, try to cap the operating expense escalations;

 

5.  Right to Audit – this right (not obligation) will allow you to audit the operating records for the building and ensure that you are only being charged for items included in your lease.

 

Ultimately, despite your best efforts and negotiating, you may have to accept that capital costs, or a portion thereof, will be passed through to you. It really comes down to the individual landlord and the amount of leverage you have in the negotiation. Asking the right questions up front, and addressing the language in the lease, can reduce the odds a nasty passthrough cost as a surprise down the road.

For questions, comments, or assistance please contact me directly.

Ottawa Office Leasing Terminology: “Gross-Up”

Office buildings are essentially made up of two different categories of space: office area and common area. Office area refers to the actual space occupied by a specific tenant of the building, while common area refers to every other square foot of the building.  The building lobby, shared bathrooms, hallways and electrical rooms are the most obvious examples of common area space.

In Ottawa, tenants pay for more area than they use exclusively. They also pay for a share of the common areas of the building, based on the percentage of area they occupy relative to other tenants. For example, if your company leases 5% of the total available office space in the property, you also pay for 5% of the monthly costs for the lobby, the bathrooms, the hallways, the electrical rooms, and all other shared areas. Landlords do this by adding area to the tenant’s usable area. This added space, or “Gross-Up”, accounts for a tenant’s actual suite as well as the area not exclusively used by the tenant.

The difference between the ‘usable area’ (i.e. the physical space that you occupy exclusively) and the ‘rentable area’ (i.e. the total area accessible to you for which you pay rent) is referred to as the “Gross-Up Factor”. Finding a building with a lower gross-up factor can save your company money. Consider a tenant that requires 5,000 square feet of usable space with a 20% gross-up factor. The 5,000 square foot user actually pays rent on 6,000 square feet. If you are paying $35 per square foot per year, on a 5 year lease, you will pay $175,000 over the life of your lease for space that is not actually yours.

In Ottawa, gross-up factors can range from percentages as low as zero, to as high as the mid 20′s, depending on efficiency of the floor plate and type of building. The average range for an Ottawa office building is 8-12%.  If a gross-up exceeds 12%, a tenant should ask themselves if they are occupying the most cost effective option.  Ultimately, the gross-up factor should be used as a point of comparison when selecting office space to lease.

For more information on Gross-up or any other leasing questions please contact me directly.