Many office Tenants focus on the first year “Base Rent” when evaluating their cost of occupancy. Or, as Tenants consider alternatives, they compare the “Rental Rate” per month or year between competing alternatives. However, negotiating the lowest Base Rent doesn’t always guarantee the lowest cost of occupancy. There are many other factors that contribute to calculating the total cost of occupancy.
Calculating Base Rent
Tenants tend to look at space requirements in terms of the actual and exclusive space they require inside a suite to conduct business. In commercial real estate terminology this is known as “Usable Square Footage”. However, Usable Square Footage (USF) does not include common areas of a building such as lobbies, shared restrooms, stairwells, storage rooms, and shared hallways.
To account for these common areas Landlords add-on a “Load Factor” to the Usable Square Footage to arrive at “Rentable Square Footage”. Load Factor (LF) varies between buildings but commonly ranges between 10% and 20%. If you require a set certain amount of Usable Square Footage, understand that not all office spaces with the same Rentable Square Footage (RSF) include the same amount of usable space that you may require to conduct business.
The formula Landlords use to calculate your Base Rent looks like this:
What’s Included in Base Rent?
Most leases in multi-tenant office buildings are “Full-Service” or “Gross”, typically defined as a lease that has one, all-inclusive Rental Rate which includes both the base lease rate and the building standard services which are paid by the Landlord combined into one figure.
In Full-Service (FS) and Gross Leases, specified operating expenses “pass through” from the Landlord to the Tenant. These expenses can include any combination of property taxes, insurance, and common area maintenance (CAM). The operating expense amount for the “Base Year” (typically the year of lease commencement or the first calendar year of tenancy) is the maximum amount of expenses the owner will pay over the life of the lease per year. Any expenses over the Base Year amount are passed through to the Tenant in addition to the Base Rent.
In California, buildings that have been owned by the same entities for a long period of time carry a large property tax liability for Tenants. Buildings like these may not have been reassessed at market value for years and in some cases decades. Proposition 13 currently limits property tax reassessments (increases) to 2% annually but allows for full tax reassessments if the building is sold, more than 50% is transferred, or substantial new construction is completed.
If a transfer occurs during the lease term, these property tax increases are passed through from the Landlord to the Tenant. It is important to consider that two alternatives with the same negotiated Base Rent may not be the same when you factor in property tax liability and the potential impact on the total cost of occupancy.
It is common practice for Landlords to include an escalation clause in the lease which increases the rate of rent over the term of the lease, usually on an annual basis. The most frequently used types of escalations are Fixed Percent (%), Monetary ($/sf), and Index (CPI). Most leases with a term longer than one year will have escalation. While most tenants want to focus on the first year Base Rent, negotiating a lower escalation clause can have a significant impact on the total cost of occupancy on a long-term lease. The larger the Rentable Square Footage and the longer the lease term, the greater impact the escalation clause will have on the total cost of occupancy.
Landlords offer concessions to a tenant to make a lease more enticing. These most often take the form of free rent and tenant improvement allowances but may also include free parking, reduced security deposit, and/or consent to sublease. When Landlords offer free rent, it may not actually be free. It's common for Landlords to add the free rent to the end of the lease term which would make a sixty-month lease with three free months a sixty-three-month lease. And, with an escalation clause the Base Rent in months sixty-one, -two, -three will be higher than the initial three months of free rent.
Calculating Total Cost of Occupancy
It’s natural for Tenants to focus on the Rental Rate when evaluating their alternatives but as we’ve pointed out there are important other factors that contribute to the total cost of occupancy. The calculation of total occupancy cost is the Base Rent paid by a Tenant over the lease term, adjusted downward for financial concessions paid by the Landlord (such as free rent), and upward for rent escalations and costs that are paid by the Tenant (such as operating expense pass-throughs).
The most effective way to negotiate the lowest cost of occupancy is to hire a broker that exclusively represents Tenants. Why? Because Landlords are focused and experienced negotiators. Landlords that deal directly with a Tenant knows the Tenant may overlook or underestimate the importance of concessions, escalations, and pass-throughs. Like Landlords, Tenant representatives are experienced in complex lease negotiations. But unlike Landlords, Tenant representatives have a fiduciary duty to solely represent your needs.