User:Leases101/Base Year Leases

Base Year Leases

This is a draft, citing and reference, and POV issues will be rectified soon

The intent and objective of a “Base Year Lease” is to have the tenant(s) fairly share in the increases of a Building’s/Project’s operating expenses (i.e., primarily increases of wage rates, utility rates, contract rates, etc.), as experienced by a “fully occupied and fully built-out” Building/Project, in excess of a designated “base” level of expenses for the same “fully occupied and fully built-out” Building/Project, and having the same type and quantity of services as were provided in such “Base Year.” Note that this “concept” is entirely different than that of a “triple-net” (“NNN”) lease, and landlords and property managers must clearly understand the difference and perform the entirely different escalation computations according to the specific type of lease.

History of the “Base Year Lease”
Prior to the late 1970’s and early 1980’s, commercial real estate landlords typically utilized Full Service Gross leases. Such leases only required the tenants to pay rent to their landlord. They were not required to share in the Building’s/Project’s expenses such as property taxes, insurance, repairs and maintenance, and as a result, landlords were fully absorbing all costs and all cost increases, including those over which they had no control. It was this latter element that created a problem for the landlords. Although portion of the tenants’ “rent” was always assumed to cover the expenses then being incurred by the landlord at the time the lease commenced, significant increases in such expenses were not envisioned, or therefore included in the “rent.” As time passed, and the expenses of the Building/Project increased, the landlord’s profits began to greatly diminish as they had to cover rising maintenance, tax, utility, and insurance costs. The reason and benefits of owning property and leasing it to tenants was being fundamentally challenged. As a result, a “Base Year Concept” was formulated wherein the landlord would assume the cost and financial risk for the operation and maintenance of the Building/Project for the first year (i.e., the “Base Year”), and the tenant would only have to pay for their share of the inflationary increases over and above the Base Year.

Basics of the “Base Year Concept”
For a particular calendar year’s expense escalations to be computed correctly under the “Base Year Concept”, the following tests are required:


 * “12-months of services test” must be complied with – each expense account in each of the Building’s/Project’s year-end general ledgers (for each calendar year) must be reviewed in detail, item-by-item, to ascertain whether or not a full 12-months of property services were recorded (depending on whether the particular expense account is subject to such a procedure). If not, the applicable number of months of expenses are to be either added or deleted to result in only a full 12-months of such expenses.


 * “Equipment/service free maintenance warranties must be accounted for as if payments had actually been made test” must be complied with – any services or maintenance on any Building/Project equipment that were subject to a “free maintenance period warranty” (e.g., in the case of newly constructed building or the installation of new equipment, the Building/Project may not be not required to pay during the free maintenance period the normal maintenance costs that would typically have been incurred if the warranty didn’t exist) must have a compatible expense amount imputed into the expense escalations for all calendar years covered by the warranty period, including any Base Year or Comparison Year.


 * “Free Rent must be adjusted out test” must be complied with – in order to correctly compute escalatable “Management Fees” for any calendar year, all free rent or reduced rent given to tenants must be fully reversed, effectively resulting in the addition of the full amount of missing rent to the bottom line of “Revenues/Income”. When this is done, “Management Fees” will correctly and more accurately reflect what they would/should have been for a “fully occupied and fully built-out Building/Project”, and will not distort the escalations in either a Base Year (to the disadvantage of the tenant and to the advantage of the landlord) or a Comparison Year (to the advantage of the tenant and to the disadvantage of the landlord).


 * “Consistency in types and levels of services test” must be complied with – each expense account in the Building’s/Project’s year-end general ledger must also be reviewed in detail, item-by-item, to ascertain whether the same type and level of services had been provided to the Building/Project (and its tenants) during the subject Comparison Year as were provided in the tenant's “Base Year” (i.e., there must always be an “apples to apples” consistency). If there is a difference, “adjustments” such as the following are required to either the tenants’ Base Year amounts or to the subject Comparison Year’s expense amounts. Note that such adjustments are required and especially important to do following the sale of a property because new owners typically operate the property differently (e.g., different level of staffing, different insurance coverages, etc.), thus mandating multiple adjustments to whatever was contained in a tenant's Base Year.


 * If the scope of a particular service is added or increased in a Comparison Year that will continue forward for many years but it was not present in the Base Year, the Base Year Amount must be “adjusted” (i.e., increased) by an appropriate amount (this is the more correct and easier process than the only other correct alternative – that of having to instead continually exclude the particular expense in the escalation of the future Comparison Year expenses). This “Base Year Adjustment” will ensure that the tenant is not paying an unfair amount for a new/increased service expense item that was not included in their Base Year, and it will also ensure that the future cost increases of this new/increased service are treated the same as all the others are being treated so that the tenant fairly and equitably shares in future rate increases (as is the intent of the Base Year Concept).
 * Likewise, if the scope of a particular service is deleted or reduced in a Comparison Year and that reduced service level will continue forward for many years but it was present at the originally higher level in the Base Year, the Base Year Amount must be “adjusted” (i.e., decreased here) by an appropriate amount (again, this is the more correct and easier process than the only other correct alternative – that of having to instead continually add an inflated amount of the particular deleted/reduced expense into the escalation of the future Comparison Year expenses). This, likewise, ensures that the tenant is paying its fair share of the costs of the Building’s/Project’s services and that the landlord is not having to absorb an unfair portion of the costs of the Building’s/Project’s services.

In short, this above-mentioned adjustment process is done simply to maintain equity and fairness for both parties in the “escalation of the Building’s/Project’s expenses” process, as was originally intended when both parties negotiated and executed this particular type of lease document. Additionally, landlords and their property managers are “ethically” required (per their moral and their licensing requirements) to perform such adjustments so that neither party is over-paying for what it contractually agreed to.

Basics of the “Gross Up Concept”
When a “Base Year Concept” lease contains a “Gross Up” provision, an even more unique animal results and an even more specific result is explicitly intended by the parties for the operating expense escalation computations. The intended result is that the playing field for escalated expenses is leveled and will only vary from year to year as a result of increases and decreases in wage rates, utility rates, contract rates, etc., and not tenant occupancy levels of the Building/Project.

According to such leases, in order for each calendar year’s expense escalations to be correctly computed, the correct implementation of the specified “Gross Up” factor is required. For example, if a particular lease has a “Gross Up Percentage” of 100% and if the Building’s/Project’s actual average occupancy for any particular calendar year was less than that stated “Gross Up Percentage”, then the certain categories of operating expenses that are affected by changes in occupancy must be “adjusted” by the “Gross Up Factor” in each such year’s escalations to reflect costs as if the Building’s/Project’s occupancy had been at the stipulated level. This, of course, gives the tenant an escalation cost “base” of a “fully built-out and occupied” Building/Project and shields it from large increases in operating expenses due to increases in Building/Project occupancy, yet at the same time ensures that the tenant and the landlord are each paying their agreed-to fair share of the Building’s/Project’s overall “consistently computed” expense increases.

While there are various acceptable ways to perform “Gross Up” computations and various expense categories may have their own entirely different methodologies, there are some fundamental requirements that all “Gross Up” computations must adhere to:


 * Only the occupancy dependent / variable component of any expense is subject to the “Gross Up” computation. The fixed component, because it is not dependent on the occupancy of the Building/Project, is not to be “Grossed Up”. Note that the determination of the fixed components can be tricky, but there are ways to figure them out, and once determined they must remain essentially fixed in future Comparison Year escalations (i.e., there shouldn’t be wild swings in their amounts from year to year), varying only as a result of rate increases associated with that particular expense component.


 * Once “Gross Up” methodologies have been established for each of the various occupancy dependent expense categories, those same methodologies must be used and adhered to in each subsequent year of the lease term (i.e., the methodologies that were used in a tenant’s Base Year must be the same methodologies used in each of subsequent Comparison Year escalations), otherwise, “Base Year Adjustments” are required as discussed above. One of the factors in determining the accuracy and use of such methodologies, however, is a sanity check to make sure the methodology in fact makes sense and is fair to both sides.


 * Expense categories that are typically “Grossed Up” include “Nightly Janitorial Cleaning”, “Nightly Janitorial Cleaning Supplies”, “Utilities”, “Management Fees”, and possibly such other categories as “Trash Removal” (if not a fixed fee under the vendor’s contract), “Interior Lighting/Lamp Supplies”, and “Elevator Maintenance” (depending upon the circumstances of the maintenance contract – i.e., whether or not an occupancy discount has been incorporated). In addition, “Property Taxes” must similarly be based upon a “fully assessed and built-out Building/Project”.

Other Requirements of the “Operating Expense Escalation Concept” and Other Specifics of a Lease
Fundamental to the overall “Expense Escalation Concept” is the inclusion of allowable/escalatable expenses in a tenant’s escalation billing and also the exclusion of all non-escalatable expenses:


 * “Escalatable expenses” include those specified in a tenant’s lease as well as those imputed by the “general wording of the lease”. For this latter group, the typical wording at the beginning of a lease’s “Operating Expenses” provision provides the guidance: “Operating Expenses include ... costs paid or incurred by Landlord ... for the operation, maintenance, management, and repair ... of the Building ...”. This general wording is important in that it defines a number of important things relating to escalations:
 * “… costs paid or incurred by the Landlord ...” means: (a) that only “real” costs and not made-up costs can be included (i.e., landlords can not just add a fictitious amount that wasn’t actually incurred/paid in that particular year somewhere in the expenses and have the tenant pay its share of it); and (b) included / escalated costs can only be those associated with (i.e., “incurred” for) that particular year and not for another year (e.g., if costs were “incurred in” / “associated with” 2007 but their payment was made in 2008, under the “Base Year Concept with a Gross Up” they must be included in the 2007 escalations and they are not allowed to be in the 2008 escalations – however, under a “NNN” lease they would generally be included in the 2008 escalations);
 * “… for the operation, maintenance, management, and repair ...” means that expenses associated with these functions are generally escalatable (subject to any “non-escalatable” provisions as discussed below), while other types of expenditures such as “capital improvements/repairs/replacements”, “expenditures incurred in anticipation of or as a result of a property sale, or financing, or re-financing” are not; and
 * “… of the Building ...” indicates what the escalatable costs can be associated with. For example, if the “Building” is part of a multi-use “Project”, then only the costs associated with this “Building” are escalatable to the particular tenant with this lease language, while all the other costs associated with the other portions of the multi-use “Project” would not be escalatable to this particular tenant.
 * “Non-escalatable expenses” include those expenses specified in a tenant's lease in its various “... not includable ...” listings, as well as other expenses sprinkled throughout in various other provisions of the lease (e.g., those expenses that are to be charged to specific tenants or are to be absorbed solely by the landlord, etc.). The proper computation of a tenant’s operating expense escalation for any particular calendar year (e.g., the tenant’s “Base Year” or any subsequent “Comparison Year”) requires that each and every expense of each calendar year be individually reviewed (e.g., usually by an item-by-item review of each expense in the property’s year-end general ledger) for “escalatability” and that expense items that are expressly “non-escalatable” according to the lease, or are non-escalatable according to industry standards, are to be excluded from the escalated totals billed to the tenant. The inclusion of such expenses would violate the lease agreement and ethics of real estate professionals.