Hidden Costs In Office Leases Many Don’t Know About

There are a number of costs in office leases and the office leasing industry that many might not be aware of.  Most full-service office leases, where the rental rate includes property taxes, property insurance, utilities, sewer, water, garbage, janitorial and building maintenance have an annual adjustment where the prorate increases over the base year are passed onto the tenant. The base year is usually the first year of occupancy.  In recent years there has also been an annual rental increase, up to recently 3% per year but with inflation I have seen more landlords ask for 4% per year, which is applied to the entire rent. This means the tenant is paying twice on that portion of the rent that is operating expenses as they are already paying their prorate increase annually. As an example, if the annual full-service rental rate is $30/rsf,  $15/rsf of this may be operating expenses. While we are on the topic of the 3% or 4% annual increases landlords may be requesting, the Federal Reserve has said publically their overall goal is to get inflation down to 2%, which means if you lock in a 5 year or longer lease with 4% you may see your rent escalating far above actual inflation figures at some point in the future.

Another office leasing factor some are not aware of is that BOMA, the Landlord industry organization (no, there is no similar group representing tenants), a few years ago re-measured office buildings and in many cases dramatically increased the size of rental square feet, to the tenants detriment. If the tenant had control of an outdoor balcony the landlord could charge the same rent on this outdoor space. I have seen a number of our local landlords back off on this when it at times can be draconian, but also have seen unaware tenants end up with greatly increased monthly rent bills. Imagine paying the same rent you pay on your inside space for an outdoor balcony you may never use!

Owning an office building might be a beautiful thing, especially when the market is tight, you have long-term credit tenants who never want to vacate, and you have little or no vacancy. However, in the real world we have submarkets where the vacancy rate is 20% or higher, tenants are down-sizing or leaving town altogether, and rental rates have remained flat for the past five or more years. Today, the cost of tenant improvements can be a nightmare for landlords. In our region of the suburbs of San Francisco, it is not unusual  to see tenant improvement costs come in at $25 or $50 or even $75/rsf or higher. To put this into perspective, if the landlord borrows the tenant improvement money at 5% interest (which today may be way too low) and amortizes it over the five-year lease term, $25/rsf would cost $0.47/rsf per month over 60 months, $50/rsf would cost $0.94/rsf per month over the 60 month lease, and $75/rsf would  be $1.41/rsf for 60 months. We are seeing these types of tenant improvement budgets in $3/rsf monthly rents, and taking the $50/rsf TI figure,  this would drop your rent before other expenses from $3.00/rsf down to $2.06/rsf, and if operating expenses were $12/annual or $1.00/rsf per month your net rent before paying your mortgage would be $1.06/rsf.  This is one reason industrial and warehouse buildings are in most cases a more preferred investment! Why do office landlords do these types of deals? The loss on keeping empty space may be far greater.