(Tenants, are you taking notice?)
Landlords’ primary business motivation is to maximise their revenues and dedicate their efforts working out how they get more money out of their tenants. Tenants, on the other hand, as occupier businesses in leased premises, have their attention focused on maximising profits from their business model.
One of the often neglected components of the cost of doing business is the idiosyncrasies of many complex clauses in lease agreements. For tenants, details are treated as unwanted business distractions, but these are great opportunities for landlords to exploit, collecting even more money from their tenants. As an example, the complexities presented in outgoings recovery clauses, in this uneven playing field, are ideal for landlords to improve investment returns. Although the rent is the primary source of income from properties, other non-rental cost recoveries all contribute to providing an overall income boost, or at least covering most landlord overhead costs.
For both, landlords and tenants, there should be a mutual desire that buildings are well-maintained and managed proficiently to deliver value for money outcomes for both parties. The structure of a tenant’s rental and payment obligations, the detailed provisions in the lease agreement and how these obligations are used or abused are key to the commercial outcomes. For example, in gross rent lease structures with limited outgoing recovery provisions, landlords can limit maintenance expenditure – this is the first budget item cut if the projected financial projections are not going to be met – even if this results in a poorly maintained building with services not supporting the tenants’ quiet enjoyment of their leased premises. In contrast, an open-ended net rent lease structure with ambiguities in the landlord’s ability to recover outgoings is a great opportunity to be exploited, particularly in a tight market with few leasing alternatives for tenants. This is a great opportunity to maximise investment income and executive performance bonuses. Tenants are locked in by their lease contracts and have limited recourse.
Outgoings are generally defined as operating costs associated with managing and operating the base building component related to management and supervision, statutory charges, insurances, common area cleaning, utility costs, security, repairs and maintenance etc. These are usually set out in lease agreements as the basis to determine what additional charges can be invoiced to tenants. From a landlords’ perspective, these definitions should be relatively ambiguous, providing the ability to have sundry costs included that should potentially not be recovered. It is usual for items of a structural nature and other capital expenditure items to be excluded from the outgoings definition – but, once again, it is best to not be too specific.
Audited outgoing statements
Outgoings recovery clauses in lease agreements ensure that a landlord has the ability to recover costs associated with managing, servicing and maintaining a building. In a net rent lease structure this will be the full annual costs as allocated on a pro-rata leased floor area of the tenancy, or, in a gross rent lease structure this will be restricted to the increase over the base year as defined. The outgoings recovery process usually commences with the landlord preparing an estimate for the year, then charging estimated monthly outgoings with a ‘true up’ payment at the end of the year. This payment – or tenant credit (but this never happens) – will be based on an audited outgoings statement prepared at the end of the financial year by an auditor, who has been appointed by the landlord. The audited statement usually only certifies the actual costs incurred and does not reference the cost items to the lease agreement.
The elegance of this process is that the landlord appoints the auditor, likely to be the company’s appointed accountants, and takes instructions from the landlord to audit accordingly. This means that the audited outgoings statement does not have to be correct in terms of the lease agreement obligations, but is limited to assessing whether the payments have been made. Astute landlords know that intercompany transfer payments for services – despite the lack of market testing – will be audited as correct, as long as these fall within the definition of outgoings.
Typically, in an investment portfolio of commercial properties, there are a number of management roles that a fund manager as landlord will need to provide to their various stakeholders. These include the funds management focused on how the overall investment fund is performing; asset management primarily making decisions related to the lifecycle and capital investment in specific buildings; property management in managing the property, vacancies and tenancies; and facility management or site supervision related to the operational management of the buildings.
The first two management roles are focused on the investment assets and maximising investment returns, and related costs should not form part of the outgoings. However, tenants (and the auditors) are seldom aware of the distinctions of these roles, so it is relatively easy to push through some of these costs as tenant charges.
The latter two management functions are related to the operations of the building and should be recoverable via the outgoings. A useful device for landlords is in charging an overall percentage (say 2.5 percent) of property revenue as a management cost (supposedly based on industry benchmarks), even if this service has been outsourced to a commercial property agent at a significantly lower percentage. This approach may include transfer payments to subsidiary companies, to enable the auditors to tick off the charges as legitimate payments.
In addition, the employment and on-costs of the personnel on the site, whether they are building or facility managers, concierges or administrative support staff, are easily argued as part of the outgoings charges – a good opportunity to double dip.
Marketing and leasing costs
Hiding marketing and leasing costs in management fees as part of a building’s outgoings is another opportunity to improve investment returns. Office buildings will at stages have vacant spaces that need to be leased, requiring the need for marketing campaigns and prospective tenant negotiations. Dependent on the size of the requirements and the state of the market, these campaigns and negotiations may be driven by asset managers, property managers or separately appointed leasing agents, or a combination of all three. Although it is generally accepted that leasing agents and legal fees should be excluded from outgoings, some recovery of these costs can be achieved based on “innovative” management contract structuring. The cost allocations can be blurred with an inherent obligation on the appointed property managers to spend a portion of their time negotiating lease renewals with existing tenants. The elegance of this device is having the tenants contribute towards the cost of the resources that they are negotiating against.
Likewise, some of the costs and time allocated to showing prospective tenants around vacancies and negotiating new leases can similarly be recovered as outgoings. Even the costs related to including marketing information on building websites can be blended in with the general updating costs. With vacancies, it is expected that the pro rata share of the outgoings related to these spaces is covered by the landlord and not distributed among the tenants. But with a few astute cost allocations, the landlord’s share can be minimised. Tenants and auditors will seldom interrogate the details of costs to this extent – remember every dollar recovered counts.
Structural and capital-in-nature costs
Industry norms define that structural costs, and those of a capital nature, do not form part of the outgoings. Landlords are generally responsible to ensure that buildings are structurally sound and in good repair, as well as watertight. Similarly, capital expenditure on items such as lobby improvements, lift refurbishments and base building plant should be excluded from outgoings. Therefore, amounts spent on maintaining the building structure and fabric integrity, as well as improvements, should not be recovered. But this depends on the definition of the maintenance items on works orders and invoices. The industry tends to grapple with definitional issues related to planned preventative maintenance, structural and capital upgrades and asset replacements. Using these ambiguities provides the opportunity for at least some of these costs to be recovered by landlords.
The decision-making related capital expenditure needing to be incurred in a building as a result of defective construction can be challenging. The required works can be undertaken as a capital upgrade project, which will not be a recoverable cost, or on a piecemeal basis resulting in higher ongoing maintenance costs, which will be recoverable from tenants. Consider, for example, a high-rise building with defective glazing causing glass panes to pop out and shatter. Ideally, the whole façade should be renewed as a major capital investment project directly impacting the investment return, but alternatively the glazing can be replaced as the panes break and these costs recovered as ongoing maintenance as part of the outgoings. For a landlord focused on short to medium investment performance, the decision outcome is obvious, albeit a management nuisance (the cost of which is, however, also recoverable.)
This article is part one of two. More ways for landlords to make money from outgoings will be discussed in our next post.