Investigating the layers of a full service lease in a commercial real estate transaction

Earlier this year, I went through the process of selling an office building that had become too big for my now “right-sized” business. Once that commitment was secured, I began the effort to seek out new office space.

My decision was to lease versus purchase, due to what many consider a “Tenants’ Market” — a clear advantage with hundreds of thousands of vacant square feet available in and around the Frederick County, Maryland area.

Not unlike clicking on an alluring link in an email or on Facebook or Twitter, there are a number of incentives that landlords may offer to attract tenants to their properties. Some of these just may be too good to be true.

In my search, I came across new shell space in a terrific location that I just could not resist. I went as far as entering into a temporary lease and occupying interim space in that building while the landlord and I attempted to hammer out a permanent deal under the following terms:

1. Full service lease that included all utilities, Landlord’s Annual Operating Costs and CAM (Common Area Maintenance) at under $20 per square foot
2. No rent at all (no utilities and no CAM either!) for one year
3. Landlord will foot the bill for a build-out of the new space at over $55 per square foot!

In the end, there were so many strings attached to the terms of the permanent lease that our negotiations broke down and I left for greener pastures.

Out of fairness to that landlord and their efforts to lease the building, I will not reveal the name or location. The intention here is to point out a lesson or two from this experience for would be tenants to use in their own lease negotiations.

So here’s the question for this post:

Is a full service lease really a full service lease?

Answer:   Well, sometimes, but often “not exactly.”

A traditional full service lease is typically understood to mean that everything is included in the tenant’s lease payment to the landlord – rent, electricity, gas, oil, water, sewer, real estate tax and insurance pass-throughs, snow removal, lawn, HVAC system maintenance, landlord overhead, management, security, replacement reserve … and sometimes even depreciation … you get the picture.

One check does it all!

Within the terms of the full service lease there is often an annual escalator that is set at some index, like the CPI or fixed to a certain percentage like 3%, which seems to be the current acceptable norm that is offered.

This escalator will give the landlord an annual increase on all those items listed above.

Here’s what to look out for: a clause that is often entitled “INCREASES IN ANNUAL OPERATING COSTS”. Its purpose is to define the specific common area operating costs (as noted above) and then provide one or more formulas for how these can be increased on an annual basis. In some cases, the landlord may put a cap on a maximum annual increase. However, very often there is no cap — just based upon actual costs. Consider, for example, snow removal costs over the last few years.

Common area management, property management, administrative and overhead fees are also often outlined within this clause. Among other approaches, check into whether these fees are based upon a percentage of expenses. Dig into the terms and find out if each of these are defined separately or rolled all into one. Administrative fees alone could be as high as 15% or more of budgeted expenses.

A clause like this is typical whenever there is more than one tenant in a building and the landlord accepts some responsibility for maintenance and oversight.

With that stated, if you are entering into a true full service lease, it really should not matter to the tenant once the lease is executed, because all of these costs are covered as a portion of the rent… and the lease terms should reflect that.

What I found within the “full service lease” proposal presented to me was such a clause with similar formulas for annual increases.  In other words that portion of the rent that is attributed to all those operating expenses can change annually, even though it is called a full service lease.  At the same time, once this portion of the rent is re-set each year, it is then increased again by that 3% escalator noted above.

Great deal for the landlord … but not so good for the tenant.  I think that’s called double dipping.

This is one of several issues that I’ll touch on in future posts that caused me to move on to my next and final destination.

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The author: Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland. He is an appointed member of the Frederick County Charter Board.  He also writes forTheTentacle.com.