The determination of outgoing recoveries can be complex, irritating and expensive. RODNEY TIMM, director of Property Beyond, reveals the ‘tricks’ that may be used by unscrupulous landlords to increase their revenues from their investment buildings.
Tenants have probably always had the challenge of having to try and reconcile their rental budgets with actual payments to landlords. Although this may sometimes be a result of poor budgeting, quite often it is the hidden costs that come through in the additional payments resulting from the vagaries of the ‘outgoing recoveries’ clause. For the uninformed, this is the clause in the lease that permits the landlord to recover the costs from the tenants related to operating the property, in addition to the basic rental payable in terms of the lease rental clause.
If a rental is structured as a net lease, this means that the tenant is liable for a pro-rata share – each tenancy floor area divided by the total floor area of the building – of the full landlord operating costs to run the building. In theory, when it comes to a gross lease structure there is no additional charge for outgoings. And, tenants in gross lease structures often – incorrectly – believe they are immune to such costs. But, the gross lease structure has evolved so that there is usually a clause permitting landlords to recovery a pro-rata share of any increases in the outgoings over the costs as at the base date when the lease was finalised. The determination of outgoing recoveries (whether the full pro-rata share as per a net lease, or pro-rata increases only in gross lease structures) can be complex, irritating and expensive – particularly if landlords indulge in ‘tricks’ that unsuspecting tenants may miss when agreeing to lease terms.
Outgoing costs are many and varied, but can be grouped into categories for easier understanding and treatment in negotiations. These categories include:
- statutory costs related to land tax, as well as local authorities’ rates and taxes
- building management costs, including fees paid to management agents, building supervision and staff costs
- maintenance costs, including routine, planned and reactive maintenance covering lifts, air-conditioning, plumbing and general repairs
- compliance and safety inspections
- security costs
- common area cleaning including external windows
- energy and electricity for common areas, as well as common services such as lifts and air-conditioning, and
- insurance costs, among others.
Projected increases and growth rates of outgoings all vary, dependent upon the inherent nature of the categories of the outgoing items. For example, repairs and maintenance items may be expected to increase by the CPI (Consumer Price Index), labour intensive items such as cleaning and security are likely to increase at projected wages growth and statutory costs increase based on local authority funding projections. Expenditure items that should not be included in ‘normal’ operating costs or outgoings are capital works and expenditure, interest on finance, marketing costs and agency fees for leasing of vacant space and legal costs, among others.
TOP 10 ‘TRICKS’
With this background on outgoings, tenants need to be aware of ‘tricks’ that may be used by unscrupulous landlords to increase their revenues from their investment buildings. The top 10 tricks are detailed briefly below.
1. Initial landlord promises
In the height of negotiations, landlords and developers tend to make promises about how efficient their building is and that the outgoing rate per square metre is lower than that of competing buildings, despite superior services because of the efficient design. But guarantees are seldom, if ever, provided. These are then the rates that are used as the base year costs for future outgoing increase calculations. Tenants are usually surprised how rapidly their outgoing charges increase off this artificially low and unrealistic base.
2. Ignoring warranties
In newly completed or refurbished buildings, it can be expected that in the initial years of operation the outgoings should start off lower than comparative buildings. This is largely due to warranties on new equipment and the newness of the building fabric. Tenants should not expect that this has anything to do with the efficiency of the building – when the warranties cease, outgoings will jump.
3. Mixed-use developments
In mixed-use developments with retail, residential and commercial accommodation, the operating costs for these different components of the development can vary significantly. For example, some operating costs related to retail are significantly higher than for commercial accommodation. So, beware outgoings that are recovered by averaging costs across the various property use categories – you may be paying a higher rate than you should be.
4. ‘Double dipping’
The classic over-claiming mechanism used by landlords to ‘double dip’ on outgoings relates to gross rental structures. This happens when a gross annual structured rent review is based on the CPI or fixed interest. Often these leases also have an outgoings increases recovery clause above the base year. This double dipping occurs because the gross base rental already includes a component for outgoings, which increases by the structured increase. And then, if the increases in outgoings are recovered on a pro-rata basis, there is in effect a ‘double dipping’ equivalent to the fixed rental increase. The correct approach should be to recover outgoings above the base year increased by the structured increase before the recovery clause is applied.
5. Capital works expenditure
This old classic is to simply treat capital expenditure spent in improving the property asset as an expense and, therefore, being able to claim it back via outgoings from tenants. Tenants should be aware that generally by the nature of most commercial lease agreements, the landlord will be responsible for structural elements, the base building and building services. Any non-maintenance expenditure on any of these aspects should not be claimed from tenants via outgoings.
6. Excessive management costs
Although it may be irritating to have to contribute to the management and supervision costs of buildings – particularly if their primary focus appears to be looking after the landlord’s interests – this is the norm in the industry. But, even more irritating are those management costs recovered from the tenants for the time, resources and expenses related to the marketing and leasing of vacant space in the building – surely an owner risk.
7. Base year date
It is convenient for landlords to have a common base year from which to calculate outgoing recoveries. The problem is that the base date may not coincide with the commencement of the lease agreement. If the base date is some significant period of months before the lease commencement, it may be a fairly short period into the lease agreement before the tenant is invoiced for their first outgoings recovery increase.
8. Interest costs
Interest charges on financing arrangements are related to the nature of capital used in purchasing the building and should not form part of outgoings. As such, tenants should be wary of landlords slipping these costs into the outgoings calculations.
9. Not appealing statutory costs
Some landlords are known to have the attitude that, because all statutory costs and increases are passed onto their tenants, it is not worth the time and trouble to appeal any statutory cost increases that result from increased land values. There should be an obligation on landlords to appeal such land value increases if it is evident that such increases are excessive. Tenants in their own right cannot appeal excessive land values, but have to bear the consequences of the landlord’s inaction via the outgoings recovery.
10. No independent audit increases
All outgoing recoveries should be audited annually before the landlord submits the increases claim. Too often, the increases are calculated by internal and not independent resources. Obviously, this is an issue if the landlord is less than honourable.
VIGILANCE IS VITAL
As with most aspects relating to lease agreements and ongoing occupancy in leased premises, outgoing recoveries by landlords from tenants are fraught with challenges for unsuspecting tenants. By being vigilant during lease negotiations and when it comes to ongoing outgoing invoicing by landlords, tenants should be able to avoid these ‘tricks’ and outgoing recoveries will be more reasonable.