In full-service gross office leases, landlords typically pass on a pro-rata share of operating expenses (OPEX) related to the tenant's occupancy of the space. In the most common office lease, tenants are only responsible for common area maintenance, utilities, property insurance, and property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date.
Each year during Q1 you and your accounting department receive estimates of current year operating expenses as well as reconciliation of previous year actual operating expenses.
What to Expect
Since landlord’s pass through operating expenses to tenants they have little incentive to control these costs. For this reason, operating expenses almost always increase from year to year. You can view any OPEX category that increases less than 3% or 4% over the previous year as reasonable while anything over that should be explained by the landlord.
Check the Math
If the Landlord doesn’t itemize your charges be sure to ask for an itemized break down by category. Whenever an annual reconciliation hits your inbox without sufficient back up to verify expenses and calculations, it’s time to check the landlord’s math and determine if a lease audit is called for. Your broker can help you check the math and assess if you are being overcharged by your landlord and assist in recovering any overpayments.
If your broker doesn’t have the time or interest to assist you it may be that their brokerage doesn’t exclusively represent tenants. The dirty little secret in office leasing is that most commercial real estate brokers represent both landlords AND tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss.
So, if your broker or anyone else in their office represents landlords, you have a built-in conflict of interest. If your broker isn’t offering to assist in your annual OPEX reconciliation, it’s probably because they or someone in their firm also represents the landlord that overcharged you for your operating expenses.
Finding the right office space can be an exciting challenge for a business. Once you've made the decision to seek your first or your next office, your instinct may be to ask Siri, Alexa, or Google search to "find office space".
Your results will be dominated by listings in free databases of office space (Loopnet, 42Floors, Officspace.com...), paid advertising listings from coworking firms and flexible office providers (WeWork, Regus, Knotel, Servcorp...), and likely some listings from commercial office brokers that represent landlords.
One of the biggest mistakes to avoid when looking for office space is not finding multiple, competitive alternatives. On the surface it may seem like your search has produced plenty of potential alternatives but in fact, the free databases, coworking and brokerage listings are populated and paid for by landlords and brokers representing landlords. Therefore, you are presented with the listings and information that benefit landlords and their brokers, not you the tenant.
Not every available office space is included in the free databases because of the cost to brokers and landlords. And, listings that are included often only quote a range of asking rents or in tighter markets, asking rents may even be WITHHELD.
Paid advertising listings from coworking firms and flexible office providers direct you to their websites to begin your deep dive into their plans, pricing, locations and FAQs.
There is nothing wrong with asking Siri, Alexa, or Google to find office space for an overview of the market through the eyes of a landlord and their brokers. But, the results are not comprehensive, lack key information and don't represent the true market condition for office space.
Consider hiring a broker that works exclusively as your tenant representative who will save you time normally spent researching space and provide the peace of mind that every opportunity in the market will be presented to you. Firms that specialize in tenant representation are only focused on finding value and multiple alternatives, many of which aren't found by asking Siri, Alexa, or Google search.
In commercial office lease transactions fees for the tenant representative are paid by landlords, not tenants. Even though tenant representatives are paid by the landlord, they work exclusively for you and unlike Siri, Alexa, or Google, have a fiduciary duty to represent your needs in everything they do.
Blockchain is best known as the technology powering cryptocurrencies like Bitcoin and Ethereum. The "block" is digital information stored in the "chain" which is a public database. The blocks on the blockchain are made up of digital pieces of information:
In contrast, the commercial real estate (CRE) industry has historically isolated information that is essential for searching, selecting and negotiating office leases behind private brokerage in-house databases and an imperfect subscription-based industry database. Much like the travel industry prior to the Internet, the commercial real estate industry is extremely inefficient and lacks transparency.
Standard operating procedure for commercial real estate brokers is to keep transaction information secret and centrally controlled for the purpose of creating competitive advantage. There is an intentional lack of transparency on the part of brokers representing landlords that increases the potential for inaccurate market information. But what if the data related to every office lease transaction and every property was held in an open and shared public blockchain database for all involved parties in a transaction?
Technology-driven information transparency is one of the major disruptive forces on the horizon for commercial real estate and office leasing. Globally, venture-backed real estate tech companies raised $14 billion USD in 2019 Q1-Q2, a 309% increase from 2018 Q1-Q2. (Source: CREtech, Mid-Year Report, 2019)
It is not a matter of if, but when. And when that day comes, you can count on an erosion of the lucrative fee structure in office leasing. The market will eventually demand transparency and the removal of information silos built and maintained by commercial real estate brokers and real estate database companies. Today, the huge commissions that brokers earn are largely justified by the existence of these silos.
Eventually, all markets demand transparency and so too will tenants of commercial real estate. As market information becomes more freely accessible the leverage in an office leasing transaction will shift from listing brokers and landlords to tenants and tenant representatives. This new market landscape will empower tenants to demand more value from their broker than just sharing proprietary market data.
That said, an office leasing transaction is much more complex than booking travel online. No two deal terms are the same just as no two spaces with the same square footage are the same just as no two landlords or buildings are the same.
So, there will be a role for a middleman in office leasing, but it won’t be about sharing lease comps or asking rents. It will be about adding quality, value and services to the transaction. Brokers clinging to legacy business models and fee structures are likely to feel like travel agents in the '90s standing on the wrong set of tracks when the Internet train passed by.
Most California office tenants know that commercial landlords typically pass on a pro-rata share of operating expenses, including property taxes, to their tenants. In the most common office lease, tenants are only responsible for property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date.
In California, 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. Under the proposed California "split roll" ballot measure, office, industrial and retail buildings would be to be regularly reassessed and taxed at their full value. As a result, property tax reassessments could have a devastating effect on California office tenants.
Buildings that have been owned and managed by the same entities for a long period of time may not have been reassessed under Proposition 13 for years and in some cases decades. As a result, these buildings carry a potentially large operating expense/tax liability that buildings with high resale turnover do not. Tenants in buildings with the most stable long-term ownership will have the largest tax reassessment liability under the split roll ballot measure.
At a minimum, it’s important to do the math on your potential split roll and/or Proposition 13 reassessment liability before entering any new lease or renewal in any building in California. Tenants need to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was and what its assessed value is today in order to forecast the potential liability due to a transfer of ownership under Proposition 13 or a mandatory reassessment under the split roll initiative. The longer it’s been since the last reassessment, the greater your exposure to property tax increases.
Average Square Footage Approach
The trend in average square footage of office space per person is clearly down. Companies have been modifying their space parameters to attract and retain the sharing generation workforce. Layouts of offices are dramatically different now than even 10 years ago. The open design has replaced a cube farm which years ago replaced enclosed large office designs.
In 2017, U.S. office space per employee dropped to 182 square feet per worker according to commercial real estate information provider CoStar. That's down from 197.3 square feet in 2010. The rule of thumb for creative open space that startup and small technology companies seek has been decreasing from 200 to 250 square feet to as low as 100 to 150 square feet of “usable" office space per person.
Space Allocation Approach
The following office space allocations can be used to help estimate the amount of usable office space required for your business based upon uses. Any common area load factors (typically between 10% and 20%) will need to be added on to determine the "rentable" area.
Keep in mind that no two spaces are alike. Look for spaces that are more efficient, like rectangular spaces versus angled corners of a building. No two spaces with the same square footage are the same. Floor plan and layout matter.
If you are planning to grow, minimize the disruption to your business by seeking termination rights and expansion rights on contiguous space. Growing into adjacent space is far less disruptive than relocating your business to another building.
Efficient space planning will not only quantify the right amount of office space but identify the office space with the best combination of value and size fit.