Limit Financial Risk When Granting Tenants an Operating Expense Cap

Death and taxes aren’t the only certainties in life. So are rises in the costs of operating commercial property. That’s why landlords generally require tenants to pay their share of operating expenses. And while most tenants are willing to go along with this arrangement, some might insist on limits, like a cap on increases or the overall pass-through amount. During these troubled times, you may have to agree to this demand, especially if the tenant is big and powerful. But you also need to ensure that a cap provision doesn’t leave you holding the bag in cases where operating cost increases are much larger than you anticipate. One method to limit your financial risks: Specify that the cap doesn’t cover costs that are beyond your control.

Carving Out Uncontrollable Operating Cost Increases

The good news is that attorneys tell us that this approach of carving out uncontrollable operating costs from the cap is one that tenants typically deem reasonable and are willing to accept, but on one important condition: You clearly and fairly identify which operating expenses are subject to the carve-out. “Not all operating expenses are beyond a landlord’s control,” according to a New York attorney. “For example, landlords negotiate and thereby exercise a degree of control over increases in the management fees they pay their managing agents.”

So, the first thing you must do is define “uncontrollable expenses” not subject to the cap on operating cost increases. Your lease clause, like our Model Lease Clause: Carve Out Uncontrollable Expenses from Cap on Operating Costs, should start by listing specific kinds of operating expenses that both sides agree are uncontrollable, including: 

Utilities. Your electric and energy rates may go up even if your use and consumption don’t increase—for example, where the government regulator grants the utility company an increase.

Insurance. There’s not a whole lot you can do to keep your insurer from raising your rates and increasing your premiums.

Real estate taxes. Your real estate tax assessment may increase even if you don’t make building and other capital improvements.

Collectively bargained union wages. Chances are that at least some of your security guards, maintenance staff, or other workers are in a union and apt to demand wage increases when collectively bargaining with you, whether directly or as part of a larger association representing local building owners [Clause, par. b].

Try to describe these carved-out expenses as generally as possible to avoid being hemmed in later. For example, use the term “utilities” rather than listing particular types of utilities. But also be prepared to compromise if tenants push back.

Leave Margin for Error

Insert the phrase “including but not limited to” in front of the list to make it clear that these aren’t necessarily the only expenses subject to the carve-out. In addition, make “Uncontrollable Expenses” a specific lease term (like Landlord, Tenant, Premises, etc.) defined as including expenses that you, in your sole discretion, consider to be subject to increases beyond your control. Reserving sole discretion should prevent subsequent disputes by tenants claiming that you didn’t do enough to control a particular expense not subject to the cap [Clause, par. b]. Tenants may insist that you exercise that discretion “reasonably,” which attorneys suggest is a concession you should be prepared to make.