Harvard Business Review

Despite getting advice from good lawyers, Fortune 500 chief executives often sign leases that cost much more than expected. This is serious, since an office lease is the second or third-biggest expense for most companies. Moreover, leases often contain restrictions that can limit or disrupt your business. The following advisory report is adapted from an article that Marisa Manley, President of Commercial Tenant Real Estate Representation Ltd. wrote for Harvard Business Review. Her views are widely discussed among chief executives, financial officers, and other real estate decision-makers.

The first thing to understand is that when you negotiate an office lease, your landlord probably has the advantage. If you’re like most tenants, you negotiate a lease once every five or ten years, and you put rent into the same category as other routine, current business expenses, weighing the monthly payment versus your cash flow.

The landlord is in a different position. Its business is leasing space, and buildings are its major asset. The landlord is highly motivated to plan for the long term and to write conservative leases that maximize the return on their assets. A good real estate lawyer can help protect your interests, but often isn’t equipped to advise on business points. Legally acceptable arrangements can be bad business deals.

Fortunately, if you’re savvy and reserve certain rights, you can turn an office lease into a tremendous asset. Here are some fine points about the most important lease provisions that protect landlords at their tenants’ expense.

Office space priced per "rentable" square foot often turns out to be much more expensive than tenants expect because landlords may include space that tenants consider unusable. Normally, you’ll be able to use only 75% to 90% of what you pay for. This difference, the loss factor, depends on three things: the physical configuration of your offices, your landlord’s method of measuring rentable area, and, increasingly, your landlord’s whim.

The rentable area is sure to include a portion of elevators, janitors’ closets, lobbies, stairways, and more. Fair enough. Be aware, however, that some buildings have a higher loss factor than others. Fancy curves or sharp angles, elevator banks placed in the center of the building instead of on the side, and an abundance of columns in your space contribute to a higher loss factor.

In addition, landlords often develop their own methods for measuring rentable areas. A landlord may measure from the outside of one exterior wall to another, for example, and include questionably "public" areas like air shafts. Some buildings seem to be measured from gargoyle to gargoyle – façade ornaments unrelated to a tenant’s usable space.

Beyond this, many landlords create an arbitrary loss factor. Once they’ve determined how big a space is, they just inflate the number by, say, 25%, and then call that the rentable area.

To protect yourself, you might hire an architect to measure the space you plan to lease and tell you whether the usable area will satisfy your business needs. The architect should use a generally accepted standard, like that adopted by the Building Owners and Managers Association, so you can precisely compare one space with another. Then, whatever number the landlord uses, you’ll know how much you’ll be paying per usable square foot, and you’ll have a more informed basis for negotiation.

On lease renewal, the tenant may also find that the landlord has "remeasured" the space and now claims it’s much larger. A well-known Manhattan landlord told a tenant I know that the tenant’s space had grown 20%. It also demanded a higher rent per square foot – a double blow.

Leases often include a clause saying that in a dispute to such items as operating costs, electricity, and real estate taxes, the tenant must pay but can take the landlord to court. This is a bad deal for you. It gives you nothing you didn’t already have, and the landlord has no incentive to settle. Time-consuming and costly litigation may leave you without an answer for years. Meanwhile, the landlord has your money, even if the court eventually finds it wrong and orders repayment.

Provide for dispute resolution in the lease. Here are a few guiding principles:

  • Arbitration may be the best method to resolve disputes like a disagreement over the fair market rent or whether a tenant’s use of space has caused more damage than normal wear and tear. Real estate experts are more qualified than the lay public to say whose right.
  • In certain disputes, the tenant should have the right to withhold operating expenses – for instance, if the landlord fails to provide essential utilities or repair services.
  • The tenant should have convenient access to documentation supporting the landlord’s bills and should be given reasonable time to audit the operating expenses. An independent CPA, not the landlord’s nephew, should prepare the statement.
  • The landlord should share certain audit costs with the tenant.
  • If it prevails in a dispute, the tenant should get a prompt refund with interest, plus reimbursement for out-of-pocket expenses and attorney’s fees.

An obvious but essential reminder: once you agree on a way to resolve disputes, follow the procedure to the letter. Paine, Webber, Jackson & Curtis, Inc. (the financial services company that was Paine-Webber’s predecessor) took its landlord to court over a dispute about operating expenses, but the case was tossed out by a judge without even a hearing. The company had neglected to start the proceeding within 30 days, as the lease required.

Basic Glossary of Real Estate Terms

This compensation for a real estate broker is factored into the rent you pay, just like the landlord's other costs of doing business. Thus, you pay a brokerage commission whether you work with a broker, and whether you retain a landlord broker or a broker who represents tenants exclusively. Doesn't it make sense to have your commission work for you by retaining a broker who serves tenant interests exclusively?

Lease costs that arise from the dynamics of building operations or other economic factors are normally considered beyond a lawyer’s expertise. For instance, some methods of charging for electricity tend to be more costly than others. Using one type of CPI will lead to higher rent escalations than if another type of CPI were used.

A measurement, typically developed by a tenant’s architect, for a given unit of space or building that describes the area in which personnel can actually occupy space and perform tasks. This involves some subjective judgments and might vary from architect to architect.

Electricity supplied to tenants for tenant use under commercial office leases is typically billed to tenants in one of three ways.

Landlord draft leases typically include many terms which will mean higher costs for tenants, even though these costs aren’t spelled out. For instance, if a lease fails to specify that a landlord is to provide certain services or to provide them at certain hours, then the tenant will probably have to lay out additional money to get those services. This kind of cost arises not because of what’s said but what’s not said, which is why many lawyers miss it.

Heating, ventilating, and air conditioning systems. Although these systems tend to last many years, the costs of operating them tend to go up over time. The failure to adequately analyze HVAC costs is an important reason why operating expenses often go much higher than tenants bargained for.

A person or firm that represents landlords and is contractually obliged to help maximize landlord revenue. Landlord brokers help maximize landlord revenue by steering tenants into buildings that such brokers represent or hope to represent. Landlord brokers invariably present a landlord draft lease to a tenant without marking it up to identify hidden costs, because raising such issues could get in the way of a deal and would, if pursued, reduce landlord revenues. Today, the largest landlord brokers represent over 40 million square of space for landlords.

A legally binding, written agreement by which a tenant, in exchange for payment, gains the right to occupy a space, land, or facility for a specified length of time. The owner of the property gives up certain rights during the term of the lease.

  • Net lease. A lease in which the tenant, in addition to rent, is responsible for paying directly for all or most (1) taxes, (2) utilities, (3) services, and (4) insurance required for or associated with the facility.
  • Gross lease. A lease in which the tenant’s base rent includes an amount for current operating expenses and real estate taxes. A tenant under such a lease may or may not pay additional amounts, often called "escalations" to reimburse building ownership for certain increases in operating expenses and taxes.

A good tenant broker marks up a landlord’s draft lease, identifying hidden costs, excessive liabilities, inadequate landlord performance standards, and other issues. Because the aim is to cut occupancy costs, which means reducing landlord revenues, it’s unheard of for a landlord broker to mark up a lease.

A lease drafted by a landlord with the aim of protecting the landlord’s interests. Calling a landlord’s draft lease "standard" is one way that landlord brokers promote such leases to tenants. In practical terms, though, there is no such thing as a "standard" lease because a good tenant representative can negotiate a far better deal for a tenant.

A written agreement by which a tenant retains a broker to act as the tenant’s exclusive representative. The broker agrees to provide specified services, and the tenant agrees to work with that broker during the term of the agreement. Exclusive agreements can be entered into on a project, regional or portfolio basis, and for varying lengths of time. An exclusive assignment for a single project is usually 12 months in duration. An exclusive assignment on a portfolio or regional basis may last two to three years. There are several critical advantages to a tenant in retaining a broker on an exclusive basis.

The difference between rentable area and usable area. In many kinds of buildings, there is a legitimate difference between rentable and usable areas attributable to common areas and facilities, such as machine rooms, bathrooms, corridors, etc. However, because a landlord’s determination of a rentable area is largely market-driven, the loss factor reflects this. Some buildings have much higher loss factors than others, meaning that for a given nominal area, less usable space is actually available for a tenant to occupy. A space with a high loss factor is more expensive than a comparably sized and priced space with a lower loss factor.

A person or firm retained by a landlord to manage the ongoing operations of a building, and often to act as an asset manager. The managing agent’s duties include preparing rent statements, preparing escalation statements, billing tenants for sundry services and in other ways acting to maximize building revenue. The managing agent is privy to the books and records for the building and, in fact, often maintains these books and records, and acts as a fiduciary for the landlord.

The actual, current costs to run a building. Operating expenses typically include such items as normal repairs and maintenance, salaries of on-site staff, cleaning costs, utilities for common areas and facilities, and similar costs. Operating expenses should exclude such items as capital expenditures, leasing costs, costs of special services provided to individual tenants, salaries of personnel above the level of the building manager, and costs to build or operate specialty functions, such as newsstand, lunch club, etc. Landlords often include in operating expenses many non-operating expense items such as capital expenditures, salaries and perks for high-level staff, costs of special services provided to individual tenants, multiple charges for the same item, etc., so that operating expenses, rather than being a reimbursement, become a substantial profit center. Avoiding this result requires knowledgeable, effective lease negotiation and audits of landlord billings.

An indexed escalation formula, used primarily in New York City or by New York area landlords. Used instead of or sometimes in addition to operating expenses. Porter’s wage escalation is based on the contract entered into every three years between Local 32B/32J building services union and a coalition of New York building owners. Many variations of the porter’s wage escalation are in common use, including:

  • Penny-for-penny fringe
  • Average of porters and cleaners, penny-for-penny fringe
  • Cleaners, penny-for-penny with fringe
  • Penny-per-percent
  • Penny-for-penny, no fringe

The most commonly used Porter’s wage variations enable building ownership to recover substantially more than they would by billing direct operating expenses. Typically, the porter’s wage escalation becomes a significant profit center for a landlord. Porter’s wage clauses can be constructed to avoid this and to provide the landlord with an amount roughly equivalent to a well-negotiated and audited direct operating expense clause.

The area (in square feet) quoted by building ownership when a building or unit of space is offered for lease. The rentable area has no necessary relationship to the actual physical area of the space offered. Pundits sometimes say that landlords use a "rubber ruler" to measure space.

The area (in square feet) of a building or unit of space is measured in accordance with some agreed-upon standard, such as BOMA, WABR, or REBNY. Typically, these standards articulate conventions for whether to measure from the inside face of a wall or its imaginary center line, how to treat air shafts, and stairwells, how to allocate corridor and bathroom areas among tenants on a multi-tenanted floor, and so on. Usable area, measured by such a standard, frequently includes an allocation of common areas and spaces that are not actually usable.

Short Course: 8 Key Questions to Ask Before You Sign a Lease

  1. Has the landlord "remeasured" space to inflate numbers used in calculating rent?
  2. Do you know how the base year in a landlord's draft lease would affect your company's occupancy costs?
  3. Is the cost of running the heating, ventilating, and air conditioning system likely to accelerate during the next lease term?
  4. Do you know whether the landlord is proposing a higher-cost or lower-cost method of calculating electricity expenses?
  5. Is the lease language specific enough when it supposedly excludes capital expenses from operating expenses?
  6. Is the landlord proposing a level of service competitive with what's available at other buildings?
  7. Are provisions about landlord performance adequate?
  8. Would a proposed lease make it necessary for your company to pay out of pocket for services you assumed would be part of the deal?

While these are only a few of the questions that must be asked before you sign a lease, they do address some of the most important issues, and if just these questions are properly addressed, a tenant will be much better off than might otherwise be the case.