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Percent Increases vs. Direct Operating

Percent Increases vs Direct Operating Office Leasing Expenses

I talk a lot about knowing your numbers when it comes to your real estate. A main component of this is the operating expense. You have the base rent amount, and then there is “additional rent.”

As a tenant in an office building, you are responsible for contributing to the ongoing operating expenses of the building. There are two main ways to participate in paying your share, through direct operating, and a fixed percent increase.

You will often hear that your first year is free, but that is somewhat misleading because standard practice is that the first year sets the bar and then you pay subsequent increases.

First, let us look at each one.

Percent increase

This is a more simplified streamlined process to pass through expenses for landlords. They collect an additional amount each year, ideally 3%, which is a cumulative compounding number. For example, $50 becomes $51.50, which becomes $53.05, or, said differently, $1.50 increase based on 3% becomes another $1.55 (3% of base rent plus 1st year of 3% rent increase). 

The short story is that cumulative compounding increases can add up quickly! While your advisor’s role is to negotiate that as close to 2% as possible, realize that this is still a profit center for landlords. Why? Because in the past, the actual operating expense increase on average have been closer to 1-1.5% (varies building by building).

Direct operating

I will be the first to say the landlords have a lot of potential headaches when running a building. One of those is managing all of the costs associated with maintaining and operating a building. The largest costs include the utilities to run the common areas (lobby, hallways, elevators), security, cleaning services, ongoing repair and maintenance, insurance, and the salaries of all the employees who help manage the building. 

During Covid, there are many other expenses to consider. These include the increased expense of signage/way finding, sanitizing/cleaning solutions to help tenants stay safe and clean while in the building, increased sanitization of public areas, increased security to ensure adherence to social distancing and limiting capacity where necessary, and one of the biggest potential costs, air filtration systems to improve indoor air quality.

When given a choice, historically, 9 out of 10 real estate advisors would have suggested choosing direct operating because it has worked out to about 1-1.5% increases per year.

Conclusion

But, Covid has given us a reason to think otherwise. There is something to be said for not having to share any of the risks associated with the building operations. With fixed increases, you can set it and forget it. Fixed will allow you to manage your own business budget by avoiding the potential surprises that could show itself by having to contribute more to the expenses of your building. You do not own it, so why do you need to guess?

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