OPEX training

February 2015

Table of Contents Introduction Tenant Lease Types Expenses Operating Expenses Real Estate Taxes Non-Operating Expenses Capital Expenses Grossing Up Expenses Other Thoughts & Summary Addenda

2

Introduction Theory of Operating Expense Escalations

o Tenant pays for increases in property expenseso Separating the Base Rent for the occupancy of the

leased premises from Escalation Rento Enables the landlord to better ensure that the “net” rent

received under the lease will not be reduced by the normal costs of operating and maintaining the property

o Landlord is able to quote a lower rent to attract tenants while protecting itself against inflation and fluctuation in operating expense and tax levels over the term of the lease

3

Tenant Lease Types

Full Service Lease or Gross Lease

Net of Electric Lease

Net Lease

Double Net Lease

Triple Net Lease

Industrial Gross Lease

Modified Gross Lease

4

Full Service or Gross Lease (FS)

Landlord pays for all operating expenses. Tenant pays a fixed amount each month based on the terms of their

lease and is assured of services for that fixed rental payment during the lease term.

Common with government tenants.

Net of Electric or “Plus E” Leaseo Exactly like a Full Service or Gross Lease except Tenant reimburses

Landlord for its proportionate share of electricity costs

Modified Gross Leaseo Tenant may reimburse LL for expenses above an agreed threshold

(expense stop). Expense Stop may be zero, an agreed upon set number or a base year.

5

Modified Gross Lease

With a modified Gross Lease, the tenant’s reimbursement is limited by either a:

Stipulated Base: An amount in whole dollars which offsets future years’ costs. May or may not reflect actual operating costs at the time of lease negotiation.

Expense Stop: An amount stated in Dollars/psf on an annual or monthly basis. Tenant pays amount exceeding the stop amount.

Base Year: Limits the tenant’s reimbursement of future years’ costs, to the extent actual expenses exceed those expenses established for a specific year. The method for establishing a base year may vary: (ex. Tenant occupies 2011)

Established per 2011 budget Established per 2011 actual (as determined by the year end reconciliation) Established per 2010 or 2012 actual (as determined by the year end reconciliation)

All recover the effect of inflation from one year to another

6

Net Leases

Net Lease - Tenant pays for most expenses and tenant pays property taxes directly to the taxing authorities.

Double Net Lease – Tenant pays for most expenses, property taxesdirectly to the taxing authorities and pays for property insurance directly to insurance company.

Triple Net Lease (NNN) - Tenant pays for "all operating expenses" including property taxes, property insurance and all other operating expenses. Tenant's rent covers only debt service and owner's profit.

7

Industrial Gross Lease

Tenant pays for all expenses inside the premises as well as HVAC for their space. o Typically electricity is separate service from provider and Tenant pays direct.

Landlord is responsible for roof, structural repairs and common area maintenance. o Tenant typically reimburses Landlord for common area maintenance expenses

such as landscaping, water for irrigation, property management and parking maint.

o An expense stop may be negotiated.

8

Expenses

Types of Expenses Incurred by Landlord

Operating Expenses (Recoverable) Real Estate Tax Expenses Non Operating Expenses (Non-Recoverable) Capital Expenses

Once these have been determined, you can begin to establish your expense pools

10

Operating Expenses

Types of Operating Expenses

Operating Expenses shall be determined annually on an accrual basis by taking into account all property expenses for: Operational, maintenance and repairs Management Parking Insurance and Fees

12

Operational Expense Examples

Costs associated with managing, operating, maintaining, and repairing: Air Conditioning Electricity Steam Heating Mechanical Ventilation Escalator Elevator Security

Includes expenses that are under contract and all necessary supplies & repairs

13

Management Expense Examples

Fees, charges, and other costs of managing the building Management Fees Telephone Service Fair Market Rent for onsite management office space Consulting, legal, and audit fees (can not be tenant specific)

Wages, salaries, and other labor costs of personnel directly engage in the management or operation of the building. Usually will stop at the Real Estate manager level or property level personnel. Includes taxes, insurance, and benefits of those employees May also include transportation and parking for those employees.

14

Parking Expense Examples

Costs associated with the parking facilityo Striping and paintingo Insuranceo Cleaning services

15

Insurance and Fee Expense Examples

Insurance Expenses Includes casualty losses not reimbursed by deductible

Business licenses and similar fees and taxes related to the building Including Bank Fees

Fees imposed by a government authority For fire and police protection, trash removal or other special services For charges of services supplied to the building by the City or County For Special Assessments

Costs of complying with any governmental laws, codes, regulations or ordinances Costs may be capital in nature Common expense would be those for ADA compliance

16

Real Estate Taxes

Real Estate Taxes

Property Taxes, Assessments and Services Real estate taxes (also ad valorem taxes) Business Personal Property taxes Tax consultant fees

Accrual versus Cash entries Margin Taxes (Texas) – tax on income of property,

established as a partial offset to existing property taxes in 2008

18

Real Estate Taxes

Handling Tax Refunds Based on Lease…Could have to calculate year associatedGenerally apply to year applicableCould be different based on Client’s direction

19

Non-Operating Expenses

Non-Operating Expenses

Costs that are not associated with managing, operating, maintaining, and repairing a building. Leasing Costs Brokerage Fees Tenant Specific items including marketing, legal, consulting, advertising fees

and tenant improvements associated with the tenant space Landlord’s general company overhead and general administrative expense

Costs Separately reimbursed to Landlord After Hours Electricity/HVAC Tenant Locks Extra Cleaning Other Miscellaneous Charges

Vacant Electricity (Industrial and Retail Buildings)

21

Non-Operating Expenses (con’t)

Financial Expenses Landlord leases land rather than purchase it Interest on loan to purchase property

Depreciation and Amortization Except on the cost of tools, maintenance equipment, uniforms, and cost

saving capital improvements used for the operation of the building

Construction costs including utilities to complete the building or any space therein

Closing Costs in connection with the purchase or sale of the building or transfer interest

Any other costs expressly excluded pursuant to any other provisions of the lease document.

22

Capital Expenses

Capital Expenses

If the value of the building is increased by the expenditure, it is a capital expense rather than an operating expense.o Capital Expenses are not usually considered an operating

expense for recovery purposes.

Capital Expenses can be included as an operating expense, if it is considered a “cost saving improvement” or if required by government regulation (depending upon lease language)

24

Cost Saving Capital Expense

Any equipment, device or other improvement contracted for and acquired after substantial completion of the building, which is reasonably anticipated to achieve economies in the operation, maintenance and repair of the building

Major Repairs: Repairs made that can demonstrate that the life of the asset has been extended beyond what was originally estimated as its useful life

Substantial overhaul of an air conditioning system that extends its life

Improvements: An improvement is a substitute that increases an asset’s usefulness only in terms of quality.

Replacement of ordinary window panes with shatterproof window panes

Replacement: A replacement is a substitution of an existing asset but unlike an improvement, it is no better than the old item when it was newly acquired but may extend the useful life

May involve replacement of a whole unit May involve extensive replacement parts

Per lease it can be passed through

25

Cost Saving Capital Improvement

Cost saving Capital Improvements can be considered a Recoverable Operating Expense and handled in one of the following ways:o Expense in one yearo Expense over the useful life without a percentage

applied as amortization (useful life can be arbitrary or GAAP)

o Expense over the useful life with a percentage applied as amortization (useful life can be arbitrary or GAAP)

26

Capital Expenses- Base Years

One time capital expenses that will be recovered, should not be included when establishing the base year expense pool. Only normal occurring expenses should be used to determine a Base Year.

However: If a $20,000 capital expense will be recovered in full for 2010.

A tenant establishing a 2010 Base Year, may still be required to pay their pro rata share of the capital item.

If a $20,000 capital expense will be recovered over the life of the asset, the yearly calculated amount may be added to the tenant’s Base Year amount that is being established.

27

Capital Expenses- Items to Note

Tenants often object to increases in their Operating Expenses due to what they consider to be major repairs, such as sprinkler installation, replacement of HVAC equipment or elevator renovation

Tenants have an option to review and audit the expenses

Leases are usually very specific about the recovery of capital expenses. If leases are vague, it is client’s decision whether to capitalize the expense or to recover as an operating expense.

Consider what the market will handle and stay competitive with your peer groups when determining if a capital expense should be recovered.

28

Grossing Up Expenses

Gross Up- Variable & Fixed Expenses

Typically, only those operating expenses that vary with occupancy are grossed up, and the ability to gross up will usually depend on the building’s average occupancy of the coverage year.

Variable Expenses may and typically do include:o Utilities o Cleaning Supplies and Contract o Management FeesThese are considered variable expenses because the cost of these expenses will

increase as the occupancy level increase (for the most part)

Fixed Expenses may include:o Real Estate Taxeso Insuranceo Snow RemovalThese are considered fixed expenses because the cost of these expenses will not

change even when the occupancy level increases (for the most part)

30

Grossing Up Expenses

Variable Operating Expenses are grossed up by Landlord so that a Tenant’s share of Operating Expenses is an amount that it would have been if the property was fully occupied

Lease provisions allowing for gross up are usually state in a percentage (%), example- gross expenses up to 95% or 100%

The ability to gross up may depend on the actual average occupancy of the property of the coverage year

In the above example, if average occupancy is at 95% then the expenses are already considered to be grossed up.

31

Grossing Up Expenses

100,000 RSF Building Tenant A occupies 50,000 RSF Tenant A Proportionate Share (PS) = 50%

Janitorial expense = $0.05 /sf /month including tax Total expense = $0.05 x 50,000 sf x 12 = $30,000 annually Based on PS Tenant A pays 50% x $30,000 = $15,000. Is that Fair? NO, since Tenant A is the reason for the cleaning cost. So, gross up. 95% / 50% x $30,000 = $57,000. 50% x $57,000 = $28,500. Now Tenant A is paying a fair share.

32

Gross Up- Items to Note

Most clauses discussing gross ups in a tenant’s lease are usually found within the same area in the lease where operating expenses are discussed.

Grossing up expenses is on a tenant-by-tenant basis. It is not required that all tenants have a gross up provision, so just because one tenant’s expense pool is grossed up, it does not mean that all the tenants’ expense pools will be grossed up.

Based on each tenant’s lease, it is the Owner’s/Property Manager’s decision to determine if expenses will be grossed up and sometimes, the landlord may choose not to gross up expenses so that expenses stay competitive.

Review for reasonableness. Grossed up numbers should not be higher than what the numbers would be at full occupancy.

33

Benefits of Gross Up

1. Gross up in general allows for more equitable overall recovery of expenses.

2. Without gross up the landlord benefits disproportionately when occupancy rises year to year. When occupancy is falling, the tenant benefits disproportionately.

3. 95% is used more often because it is rare for a property to be at 100% occupancy (although it may be 100% leased).

4. Usually in recovery calculations, occupancy is based on leased occupancy not physical occupancy.

34

Other Thoughts

CAPs on OPEX Escalations

Expense Cap: An artificial ceiling is created to limit the amount the tenant may pay in Operating Expenses. Used to control the amount of expense increase from year to year.

Can be placed on specific expenses (usually controllable expenses) to limit the amount of increase on those expenses from year to year.

o 5 - 8 % CAP on controllable expenses from one year to another is typical

o Controllable expenses usually exclude utilities, real estate taxes, and insurance since these expenses can not be controlled by the landlord

May be placed on a single expense categoryo $0.25 CAP on the increase in Management Fee expense from one year to

another

36

Handling CAPs

Example APrevious year’s controllable expenses $258,0005% CAP $270,000Current year’s controllable expenses $263,000

In this scenario, you would use the $263,000 (non CAP) as your controllable expense pool and add your uncontrollable expenses back in for a total expense poolFor the next year, what amount will you place the 5% CAP on?

Example BPrevious year’s controllable expenses $237,0002% CAP $242,000Current year’s controllable expenses $251,000

In this scenario, you would use the $242,00 (CAP) as your controllable expense pool and add your uncontrollable expenses back in for a total expense poolFor the next year what amount will you place the 2% CAP on?

37

CAPs (continued)

The previous year’s expenses may be different for each tenant due to gross up clauses that may increase one tenant’s controllable expense pool over another tenant’s expense pool.

Current year expense pools, before any CAP calculation, may also be different per tenant due to gross up clauses.

Because of the above two possibilities, each tenant must be taken on a case by case basis when determining their expense pool and calculating their operating expense reconciliation.

Because of the variables involved in CAPs, it is imperative that you track the expense pools for each tenant each year.

38

CAPs (continued)

One very important item to understand with CAPs is how they should be calculated: Year over Base – limit expense increases to a fixed amount each year, as a % of expenses at beginning of lease term.

Example - if starting base amount is $100 and the cap is 5% year over base, then the maximum expenses in following years are: $105, $110, $115, etc.

Year over Year – calculated by applying CAP to the prior year’s expenses.

Example - if starting base amount is $100 and the cap is 5% year over prior year, then the maximum expenses in following years are: $105; if actual expenses the following year are only $102, then the following year the cap is 5% above that amount of $107.10.

39

Summary

Calculating Operating Expense Adjustments is an art, not a science

Precedence is a factor, so errors on the part of past owners and managers may very well affect what can be charged in the future (mgmt. fees, Real Estate taxes)

There is a burden placed on each Property Manager to protect both his owner and his tenants from errors in Operating Expense Billings

Will have multiple expense pools based on lease terms

40