How a great location became a bad deal
The story of a Fortune 500 office lease
Above: A tenant is supposed to pay operating expenses, the cost of operating the building they're in, but not the landlord's overhead which includes, for instance, the cost of developing and managing other buildings a landlord owns. Yet in this seemingly simple clause, the Fortune 500 company we're discreetly calling "XCORP" has agreed to pay the landlord's overhead.
It doesn't matter how much a brokerage firm knows about the real estate market if it can't negotiate a great lease for a tenant.
A badly-negotiated lease can easily cancel out the advantages of a great location -- and even imperil a business.
Take a company which we'll refer to as XCORP which signed a lease in one of Manhattan's most prestigious Class A office buildings with a skyline signature. The lease locked in a low base rent for 15 years.
The corporate executive who signed the lease had much prior real estate experience. The lease was a major cost of the company.
The company had the advantage of shopping for space during a down market when some of the most famous landlords like Donald Trump and the Reichmann brothers lost control of their properties to banks.
Yet XCORP's lease costs soon climbed ominously. Moreover, when the real estate market became hot, XCORP's top executives were shocked to learn the lease permitted the landlord to evict them, and suddenly they faced the prospect of having to struggle with even higher occupancy costs.
Here are the most important issues and costly lease traps in the XCORP lease -- issues and traps which occur in plenty of Fortune 500 leases:
1. Operating expenses. As is the case with most contemporary leases, the tenant agreed to pay a portion of the landlord's operating expenses. Operating expenses are commonly understood to be the normal cost of operating a building. They are not intended to cover improvements to the building, costs of attracting new tenants, landlord's corporate overhead and other costs not directly related to building operations.
Operating expense provisions, however, are frequently used by a landlord as a hidden profit center. Hidden because their dollar significance is not disclosed to the tenant when a lease is signed, and the methods landlords use to increase operating expenses are often less than straightforward at best.
XCORP agreed to one of the worst operating expenses provisions we have seen. It practically gives the landlord a blank check.
For instance, XCORP agreed to pay a management fee (for the landlord's in-house management services) that is "consistent with Landlord's standard practices". This means if the landlord bills a management fee that is 300% or 500% or 1000% higher than its cost or the prevailing market rate or any other objective standard, XCORP as a tenant is still obligated to pay that fee under the lease.
Although XCORP's lease seemed to define what may be billed as operating expenses, and listed specific exclusions, XCORP accepted lease language stating the landlord's actual operating expenses, "are intended to constitute a formula for an agreed rental escalation and the computation may or may not constitute an actual reimbursement to Landlord for costs and expenses paid by Landlord in connection with the [Building]." While such language is appropriate for lease with a porter's wage, CPI or other indexed escalation, it backfires and becomes a landlord's sword instead of a tenant's shield in this situation.
XCORP agreed to let the landlord bill "capital expenditures which under generally applied real estate practice are expensed or regarded as deferred expenses and...capital expenditures made by reason of Insurance Requirements or Legal Requirements..."
Sounds legit, like the well-known Generally Accepted Accounting Principles (GAAP). But try asking for documentation on "generally accepted real estate practice." There isn't any such thing. No documentation whatsoever.
Furthermore, accountants will tell you that "deferred expense" is another term for capital expenditure. In essence, XCORP's lease says that capital expenditures were excluded from operating expenses unless they are generally regarded as deferred expenses like capital expenditures.
Since the obvious intention was to bill tenants for capital expenditures, naturally the landlord sought to prevent XCORP from challenging the bills. Incredibly, XCORP executives agreed that if they fail to challenge the landlord's annual operating expense statement within 30 days, they forever waive their right to do so. They have simultaneously agreed that the landlord has an unlimited amount of time to render operating expense statements, and that having once rendered an annual statement, they may revise it as many times as they see fit.
This means XCORP could be hit with operating expenses years after they were supposedly incurred. Some tenants have renewed leases only to see their escalations jump because of unexpected landlord bills from their previous lease term.
2. Electricity. Costs of electricity frequently exceed 10% of base rent and can be significantly more. It's no wonder when you consider that most tenants in office high‑rises cannot get to their premises, and in a sealed building, cannot comfortably breathe without electrically powered elevators, heating, ventilating and air conditioning systems. Then there are the need for electricity to power lights, computers and other kinds of office equipment. A properly-negotiated lease provides controls for electricity costs.
Yet XCORP executives signed a lease which didn't specify how much electricity was to be provided and which left electricity costs wide open. As their lease put it, electricity would be at the "Landlord's sole option and at Tenant's sole cost and expense..." There's no limit to electricity costs. Moreover, the landlord could decide to install a new metering system which XCORP would pay for. The cost is in no way limited, it's not required to be amortized, can be billed in a lump sum, and is not required to be allocated among other tenants who may also be similarly metered.
3. Audit rights. To maintain prudent financial controls, corporate executives must be able to verify the legitimacy of expenses -- especially significant expenses such as occupancy costs. This is to guard against human error, bad judgment and occasional dishonesty.
Incredibly, XCORP -- which pays thousands of dollars of escalation charges per month -- did not reserve a right to audit the landlord's books and records to determine if billings were properly computed in accordance with the terms of the lease. While XCORP probably could gain access through either litigation or arbitration, doing so would likely involve substantial time and cost. This in itself would deter many tenants from determining whether they are being overcharged.
XCORP executives also agreed that if the landlord has overcharged them on operating expenses, after they have spent the money to prove this overcharge through an audit and arbitration, the landlord has his option of deciding whether to give XCORP a credit or make a refund, how long a refund might be stretched out. And of course, XCORP isn't entitled to any interest on overcharges.
4. Liabilities of building ownership. As a way to cushion the risks of property ownership and spread costs, many landlords seek to have tenants bear costs, especially capital costs which arise from so-called legal or insurance requirements. Tenants who agree to bear any portion of such costs should certainly limit their financial liability to legal requirements arising specifically because of something they do.
XCORP accepted these liabilities of building ownership. Consequently, XCORP could be hit with costs, imposed by law, that don't even relate to their leased space. They could be forced to pay for costs of common areas and the building generally.
5. Cost of repairs. It's customary for tenants to pay the cost of normal repairs to their own space.
XCORP's landlord demanded much more, and the company's executives seem to have given the landlord everything. For instance, XCORP's executives agreed that whenever the landlord must make repairs, the company will pay the landlord its full cost, plus a 21% mark-up.
Many landlords demand the right to enter a tenant's space to repair it and perform work affecting other spaces. Well-advised tenants can oblige the landlord to minimize interference with tenant operations and reduce rent when the space they lease is reduced because of the landlord's activities.
But XCORP agreed the landlord can install and maintain in their leased space unlimited ducts, conduits, chases, and other equipment related to the mechanical, structural, security, building management systems -- all without any compensation to XCORP for interfering with their operations or diminishing their rentable area.
Understand that work on a building's systems is frequent, noisy and dirty. Moving workmen and equipment in and out is hard on walls, carpeting and more. Columns that get "boxed out" to accommodate additional electrical risers, plumbing chases and the like make space smaller, less attractive and less useful. XCORP agreed to take on all these problems with no remedy.
6. Heating, ventilating & air conditioning costs. Under the terms of this lease, the landlord has agreed to provide base building systems, and has given XCORP the right to install supplementary systems. This is a fairly customary arrangement. XCORP has agreed to pay all charges for HVAC services; such an arrangement can be entirely satisfactory, depending on what other charges are billed to the the tenant and how this concept is implemented.
XCORP has virtually assured itself problems by agreeing that any bill for HVAC the landlord renders will be conclusive and binding -- not subject to further question or challenge -- unless within 30 days after receiving the bill, the "Tenant shall demonstrate, in writing, to Landlord's satisfaction, that the calculations of the charges set forth in such bill are incorrect specifying the particular respects in which such calculations are claimed to be incorrect." No outside review or evaluation is provided for. The landlord alone decides.
Moreover, how is XCORP, within 30 days, to provide a challenge to the landlord's particular practices, when it does not have access to the landlord's books and records, the engineering specifications, details of staffing, other tenants' usage, and a dozen other factors which affect the proper billing of HVAC charges? Standard and supplemental HVAC charges for even modest tenants readily exceed several hundred thousand dollars per year, but this tenant has no apparent way to get the information necessary to monitor these charges; and no effective way to challenge, since the landlord is both perpetrator and judge. Yet, this lease was signed by an experienced tenant who fully understands the importance of controlling occupancy costs.
7. Cleaning services. Standard cleaning costs are often included in base rent and operating expense increases which a tenant has agreed to pay.
XCORP and the landlord separated cleaning costs from other operating expenses, and XCORP agreed to have the landlord retain contractors and bill for the service.
The lease permits the landlord to own the contractors, which almost always means above-market rates for tenants who are a captive market.
In addition, XCORP agreed to pay a 21% management fee!
No tenant benefit in any of this.
8. Notice provisions. These are likely to be little-read, but they can be critical to a tenant's financial liability. For instance, a notice containing an annual operating expense statement, or a notice of a requirement imposed by law that the tenant will be obligated to pay for. Certain procedures should be followed to assure that such notices go to an individual with responsibility to take appropriate action.
XCORP's executives accepted pro-landlord notice provisions which leave the company vulnerable to substantial liabilities. The lease says that any XCORP notices for the landlord must be sent certified or registered mail and delivered to three persons: the landlord's executive vice president, counsel and managing attorney. By contrast, the lease says that landlord notices to XCORP may be delivered personally, with no proof of receipt required, and such notices may be left with anyone at the premises, including a temp, who probably has no idea how XCORP could be penalized if a notice is misplaced.
9. Tricky definitions. Leases commonly define key terms used throughout the lease. This is boring stuff with immense implications.
XCORP's lease defined terms to twist customary meaning and set up XCORP for unexpected liabilities. For instance, page 13 of XCORP's lease says the landlord may bill XCORP for "repairs" of equipment. "Repairs," according to the accounting profession and most lay people, are different from "replacements." But on page 61 the lease defines "repairs" to include "replacements" and a variety of additional work not customarily understood by the term "repairs."
The landlord also stipulates that XCORP's every "covenant" is also a "condition." How does this bit of language play affect XCORP's financial obligations? The landlord is saying here that XCORP's exact observance of every promise, no matter how trivial, from putting down the blinds on a sunny day, to cleaning its premises in a manner satisfactory to the landlord, to paying the rent, is a condition that precedes any obligation the landlord might have to make even essential repairs or provide critical services. Far from a necessary protection for the landlord, this is a classic hold-up, used to extract mid-term concessions from an unwary tenant.
A great lease negotiator is essential
if your company is to gain the advantages
of a great location
Here we have a lease agreed to by an experienced tenant in a prestigious Class A office building during a major real estate market downturn, when good deals for tenants are supposed to be a piece of cake.
Like most corporate real estate executives, XCORP's executives focused on a few conspicuous terms expressed in dollars, particularly base rent and workletter. Apparently XCORP's executives treated the rest of the lease as "standard fine print" which somebody else (their lawyers) would look over.
After having signed a 15-year lease, XCORP's executives were shocked to find that "standard fine print" concealed traps which approached the cost of rent and undermine their company's competitive position myriad ways. XCORP's lease obliged the company to pay exorbitant and in some cases unlimited operating expenses. Often performance standards for the landlord were too vague to be meaningful. XCORP had no right to understand the basis for any landlord bills in a timely way. They were limited in their ability to challenge these bills.
XCORP's lease called charges for electricity, HVAC, the various management fees and so on "Additional Rent." Failure to pay "Additional Rent" is as serious as failing to pay base rent. XCORP agreed the landlord could levy serious penalties and evict them for non‑payment if the situation continued for more than a few days.
The result of all this, as noted, was that total occupancy costs soared far beyond what XCORP's executives had anticipated. Because they were caught unprepared, the lease costs threw off their strategic plans. Today the company is in financial trouble.
Fortune 500 leases are plagued with the same kind of traps that wiped out the advantage of a great location for XCORP.
The lesson here is that a company can incur big, unwanted liabilities if it selects a broker only by its supposed knowledge of the market. Especially since landlords, eager to attract tenants, let everybody know about any available space they have, and all brokers have access to databases which cover the market.
Landlord brokers don't alert tenants to lease traps because such brokers have fiduciary obligations to increase landlord revenue.
In New York City, you can probably count on a few fingers the individual brokers who are lease negotiators, going into "standard fine print." Brokers generally focus on getting a deal (any deal) done.
Lawyers tend to overlook lease traps which involve market, operations or accounting issues.
To gain the advantages of a great location, you need a great lease negotiator who combines expertise in real estate markets, expertise in real estate law, expertise in building operations, expertise in landlord accounting practices, expertise in real estate negotiation itself -- and a policy of representing tenants exclusively.