The Effect of COVID-19 on Operating Expenses in 2020
It is vitally important for businesses to carefully consider the various ways COVID-19 will impact their real estate operating expenses in the foreseeable future. CBRE has compiled the following information to help pinpoint these considerations.
Landlord vendor agreements with janitorial firms contain sections for vacancy credits:
- Expect janitorial as a category to be under budget
- Occupiers should expect reductions with vacancies or closed buildings
- Gross leases for which 2020 is the base year may see the opposite effect – with these atypical janitorial costs not properly grossed up to account for a fully occupied building
After 9/11, landlords started to pass through to occupiers the cost of Terrorism Insurance – regardless of the lease identifying the insurance as an allowable passthrough. As a result of COVID-19, Pandemic Insurance may well follow suit:
- Landlords will attempt to pass this cost through regardless of the lease language that carefully identifies permitted coverages and amounts
- New leases should consider this insurance as an incremental expense
CAPS ON CONTROLLABLE EXPENSES
Some leases vaguely differentiate controllable vs. uncontrollable expenses:
- Landlords may interpret COVID-19 as uncontrollable, leading to excessive overcharges (i.e. taxes, utilities and insurance deemed uncontrollable)
- New leases should specifically define controllable expenses, eliminating landlord interpretation for their sole benefit
- New leases should consider clarifying the requirement for the landlord to annually bid their insurance coverage. This will ensure that the tenants are paying the lowest rate for comparable coverage
REAL ESTATE TAXES
Consider the potential impact of vacancies on failed businesses:
- If property taxes are based on the income approach, any appeals would carry a multitude of impacts on operating expenses. However, we may not see these impacts until the next assessment, which could be two to three years out.
Every lease is different when it comes to whether, and what type of, capital expenditures are allowable as operating expenses either in total or amortized over their useful lives. Landlords may have to make significant changes to the building for health and safety purposes and will be looking to pass these expenses off to tenants:
- Are these improvement projects for life and safety and, therefore, considered allowable capital?
- Is the landlord using the appropriate useful life when amortization is required under the lease?
GROSS LEASES WITH BASE YEARS IN GENERAL
Leases still in negotiation should entertain language that appropriate base year adjustments/gross-up provisions, to address COVID-19-related disruptions, are required of the landlord:
- Landlords will be inclined to leave the base year artificially deflated, resulting in over-inflated CAM contributions for occupiers for each year following the base
- Any error in the landlord’s favor will have a significant impact over the life of the lease
- Increased risk for occupancy to be improperly grossed up for temporary closures related to COVID-19
- Be wary of relying solely on gross-up provisions for appropriate adjustments due to COVID-19, as it will depend on the definition of ‘occupancy’ per the lease. If leased but temporarily closed, is the premises occupied?
- If new standard costs will be incurred due to the fallout of COVID-19, look to the lease to determine if a prior year base year can be adjusted to account for these new annual charges
TRAVEL FOR AUDIT
COVID-19 is an opportunity to start changing the standard audit clause language that suggests lease auditors must travel to obtain the landlord documents:
- Given technology and electronic capabilities, there is little need to require travel to perform an audit
- Forensic examinations remain an exception
Some leases contain language that suggests any losses in operating amenities – such as cafeterias or fitness centers – are valid operating expenses and can therefore be passed through to tenants. As such losses are expected to accumulate during the pandemic, this can have a sizeable impact.
There may be additional security costs associated with stopping unmasked individuals from compromising an office or a retail establishment. A base year established pre-pandemic will not take these costs into account.
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