What is a base year in a lease (and why is it so important to understand)?
The ‘base year’ is the first calendar year of a commercial lease agreement and it affects how tenants are charged for building expenses in the subsequent years. So, it’s important to understand how it works when it comes to commercial leases and how it can affect your bottom line.
The base year mechanism
In the base (i.e. first) year of a lease, the landlord typically predetermines the operating expenses of a building, like council rates and insurance, as well as cleaning and maintenance of common areas. The building operating expenses are set based on the tenant’s occupancy share of the premises.
However, from the second year on wards, tenants are required to pay a proportional increase of any building expenses, based on their occupancy share of the premises.
Here’s an example…
For example, if you as a tenant are leasing 20% of the available office space in a commercial building, then you’ll be expected to pay 20% of any increase in the building’s general operating expenses after the base year.
So, if the building’s expenses increase by $50,000 in the second year, you’ll be up for $10,000 of this additional cost (i.e. 20% of $50,000).
Are annual increases in outgoings and rental increases the same thing?
No, they are not.
Let’s keep working from the example above – our building expenses are $50,000 and we’ve agreed to pay 20% ($10,000).
Now say your rent was $100,000 in year one and you negotiated to pay 20% of the building’s expenses ($10,000), you’ll be up for $110,000 in the second year (and even more if your rent is also set to increase annually).
What’s the point of a base year provision?
Base year provisions are generally designed to protect landlords from significant increases in building expenses. However, poorly negotiated base calculations can potentially cost tenants thousands of dollars.
Scenarios to watch out for
1. The potential for variable expenses to increase significantly
One of the most common ways that this can happen is via a significant increase in utility bills, like electricity.
For instance, if you move in early to office space in large premises that is mainly unoccupied, you can expect the utility bills to be much lower than if the building was fully tenanted.
This process of leasing vacant space can take a while. That means that the landlord’s base year expenses might be low at the start, but the costs in subsequent years will be high once the building is fully occupied.
You’ll be responsible for your share of any increases. So, it’s important to protect yourself by negotiating a ‘gross-up’ clause in your lease that limits your exposure to future increases. This clause recalculates the landlord’s base year expenses so that they reflect a more fully occupied building (such as 80% or higher).
2.The landlord deferring expenses
It’s also important to be aware of scenarios where a landlord can potentially profit from the base year calculation so that it works in their favour.
A landlord looking to save money on their building’s expenses can potentially defer some costs (like elevator maintenance) so that they fall outside of the base year.
That means their tenants will be liable for them in the second year.
To avoid this scenario, you should thoroughly audit the landlord’s operating expenses and asset maintenance records as part of the lease negotiation process and your due diligence.
What can I do to avoid a landlord deferring their expenses?
To avoid this, you should thoroughly audit the landlord’s past operating expenses and asset maintenance records as part of the lease negotiation process and your due diligence. At a minimum:
- Look into the building’s expenses for the last three years. This should give you a fair indication about the average annual increase of outgoings and how you should budget moving forward
- Negotiate a clause in your lease that allows you to request an audit of the operating expenses before you pay the increase
- Make sure you ask about upcoming works and negotiate your base year around planned activities.
How Tenant CS can help
It’s no secret that commercial real estate leases are complicated. What’s more, if they are not negotiated correctly, they can come with a range of hidden costs that affect a tenant’s bottom line. That’s why it’s important to get a team of professionals on your side.
Tenant CS is a commercial tenant advisory service that caters to businesses across Australia (with a particular focus on office space in Sydney, Melbourne, Perth, Adelaide, Brisbane and Canberra), Singapore and the greater Asia-Pacific region. We’re well versed in the ins and outs of commercial real estate.
So, for your next commercial lease negotiation, contact a member of our team. We will help you to negotiate the most favourable terms and conditions. We’ll also help you better understand commercial lease structures, such as base year expense calculations, to minimise your risks and costs.