Operating Expense Reconciliation: How to Minimize Surprise Costs

'Reconciliation' in block letters

If you lease commercial space in Ottawa, you likely have a net lease.  Your net lease can require that you pay property taxes, insurance, maintenance, management fees, repairs, and sometimes utilities in addition to the set net rent (also known as base rent or minimum rent).

At the beginning of 2019, your landlord would have budgeted for the expenses to operate the building like property taxes, maintenance and repair, janitorial, snow removal, utilities etc.  This budget is used to calculate the additional rent per sq. ft. for 2019. Then, you’re charged you accordingly based on the rentable area you occupy. 

Landlord reviewing expenses and performing calculation

With 2019 ‘in the books’, your landlord will be comparing the actual operating expenses from last year to what you were charged you in additional rent – generally referred to as the ‘Operating Expense Reconciliation’ process. 

For example, let’s say that your landlord estimated that the total annual operating expenses for your 50,000 sq. ft. building was going to be $750,000 for 2019.  As such, you and the other tenants in the building would be charged $15.00 per sq. ft. in additional rent in 2019 to cover those expenses ($750,000 / 50,000 sq. ft. = $15.00 per sq. ft. additional rent).  So, if you occupy 5,000 sq. ft. of the building, you paid $75,000 toward the building’s operating expenses in 2019. 

Let’s suppose your landlord reviews the actual expenses from 2019 and calculates that it cost $757,500 ($15.15 per sq. ft.) to operate the building instead of $750,000 ($15.00 per sq. ft) – so they undercharged you by $0.15 per sq. ft. in 2019 ($15.15 – $15.00 per sq. ft.).  In this scenario, you would have a balance owing of $0.15 per sq. ft., and you would be receiving an invoice for $750 (5,000 sq. ft. x $0.15) to cover your share of the shortfall.  Conversely, if the actual 2019 operating expenses had been $742,500 ($14.85 per sq. ft.) instead of $750,000, you will be receiving a credit of $750 ($15.00 per sq. ft. paid – $14.85 actual expense) toward your rent in 2020.

The expense reconciliation process is standard if you have a net lease. Because it’s impossible to project variable costs with absolute certainty, you should expect some variations in operating expenses.  The issue is when there’s a significant gap between the budgeted operating expenses you are charged in additional rent and the actual costs to operate the building. Using the example from above, $0.15 per sq. ft. or $750 would not likely have a significant impact on your budget, but what if the balance owing is $1.50 per sq. ft., or $7,500?

Man scratching chin and thinking

So how can you be sure that the operating expenses and reconciliation process are fair?  Aside from avoiding dishonest landlords, I highly recommend that you consider the following during the leasing process:

1. During Your Search

Compare Expenses with Market Averages

All things being equal, the operating expenses of comparable buildings in comparable locations will be similar.  If the operating expenses of a building you are viewing are well below those of similar buildings, it is important to ask why. Are lower due to operating system efficiency and prudent management?  Or, are the estimated expenses being held below the market to make a building price competitive?  If a building is simply more efficient, great.  But if expense projections are intentionally low, only to hit tenants with a big operating-cost-balance-owing-invoice at the end of the year. That’s not so great.

2. During Negotiations

Expense Cap on Landlord Controllable Costs

Although your landlord has no control over property taxes, insurance, and utilities, they can control management fees and service contracts for general maintenance, snow removal, security, etc.  Depending on market conditions and your negotiating power, you may be able to cap the maximum amount that your landlord can increase controllable expenses.  A cap provides both a safety net to you and an incentive for your landlord to manage operating expenses prudently.

Right to Audit

If you have the right to audit the buildings operating expenses, you can review the landlord’s books to ensure the actual operating expenses align with what you were charged.  Many landlords will agree to your right to audit if the annual increase in operating expenses exceeds a reasonable level (beyond inflation), that the audit occurs within a certain amount of time, and with appropriate notice. 

man reviewing document with magnifying glass

3. During the Term

Review the Operating Expense Statements

Commit the time each year to review the Operating Expenses Statements that you receive from your landlord and to ensure that they remain consistent with the terms of your Lease.  No one wants to be charged for more than their fair share.

Whether you’re searching for space, negotiating a lease, or are in the middle of your lease term, it is important to pay close attention to a building’s operating expenses.  Even the most professional landlords and property managers can make mistakes during the operating expense reconciliation process – catching these mistakes can prevent significant surprise costs.

Do you have a question about your operating expenses? Send me an email at jeff.daniels@royallepagecommercial.com.