Starboard Commercial Real Estate

Hans Hansson | September 19, 2005

When a commercial broker adds the words "base year 2006" to an office leasing proposal, the first question most clients ask is, "What is a base year?" Brokers usually simply add the year (Base year: 2006) to a proposal. Yet, base years can be quite complicated and can be calculated a number of different ways that could affect the rent a tenant pays for new office space.

Commercial rent is calculated using three different methods: fully serviced, gross or industrial gross, and NNN. Under a fully serviced lease, the landlord pays for the first year's operating expenses, including the tenant's utility and janitorial usage. The landlord also pays for the tenant's share of building insurance, taxes, maintenance, and management. Under a gross or industrial gross lease, the landlord covers everything but utilities and janitorial usage. Under an NNN lease, which is not as common in office space use, particularly in California, the tenant pays rent and pays a separate charge for a share of expenses incurred in operating the space as well as the entire building.

After the first year of operation, however, all three leases essentially become the same because of a base year clause. Under a fully serviced or gross lease, after the first year or base year, the landlord is entitled to pass on to the tenant any increases incurred in operating the building. Tenants under an NNN lease continue to pay the cost of operating the building.

Base years can be calculated and assessed in a number of different ways. Some landlords determine projected increases over a tenant's base year at the beginning of the year. The tenants make these additional payments each month. At the end of the year, actual expenses are compared to projected increases and an adjustment is made. The reverse is also done: The landlord waits until actual expenses are incurred and then bills the tenant for these increases at the end of the year.

Larger landlords can provide 12-month protection to a tenant to cover one full year of expenses. However, if a tenant moves in during the year, for example, in June, and does not ask for 12-month protection, that tenant could be subject to an increase in January.

Usually, after September a landlord will concede to the next base year. In other words, if a tenant signs a lease for a move in September 2005, the landlord will concede to a 2006 base year, giving the tenant 16 months as a base year instead of 12.

Most tenants wanting to protect themselves against uncontrolled operating expenses ask for a cap on pass-through operating expenses. Landlords rarely give this. To maintain the lease rates agreed to by both parties, landlords need to be able to pass on increases to tenants.

It is also to the advantage of the landlord to keep operating expenses down even if the tenant's pay for these operating expense increases. Net rent is determined by taking gross rent and subtracting operating expenses regardless of who pays for them. Net rent in turn is capitalized by a factor to create a value for the building. The greater the operating expenses are, the less the net income is, creating a higher value for the building.

Tenants should focus on ensuring that they get full 12-month protection. They should also ask for two or three years of historical data to see trends. Finally, tenants should do the math. Particularly for tenants leasing less than 5,000 square feet, pass-through operating expenses often do not represent significant added costs.
Posted 14 years, 6 months ago on September 19, 2005
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