Whether you are purchasing a piece of property outright, investing in a building, or leasing a commercial space for your own business, it’s important to understand commercial real estate operating expenses, since they impact both tenants and net operating income (NOI) for the owner.
The smart property manager considers their expenditures when budgeting and knows how to minimize these business costs and negotiate favorable contracts, including monitoring how much is being spent and adjusting rates as necessary. For the inexperienced owner, not knowing how to calculate or structure these into a contract can be detrimental to their financial goals.
Often abbreviated to opex, these are the charges associated with maintaining and running a commercial property, such as an office building, retail space, or warehouse. They are part of the overhead and can be as important as the mortgage.
Depending on the building’s lease structure, these expenditures may be a component of the gross rent or be in addition to the base rent. In multi-resident buildings, each tenant is responsible for their share of management costs, which depends on the rentable square footage compared to the total rentable square footage of the building.
It should come as no surprise that the running costs of a building depend on the class of commercial property. An office or retail space will have different expenditures than a multi-family building. Many of the costs passed to renters are shared between lease holders and the owner in a commercial property. These include:
There are a few major charges not included in a property’s costs, although it’s important to note they may still be part of an owner’s responsibility. These include:
The formula used to determine NOI is meant to deduct the costs from gross operating income. Any landlord looking to maximize profits would benefit from minimizing expenditures or passing them along to residents. Another important formula to consider when evaluating properties is the operating expense ratio (OER). This is the costs to operate the property, not including depreciation, divided by gross operating income. A lower OER is better, as it usually indicates minimized expenditures and higher profit margins
The residents of a building generally split the financial burden of operating costs, paying based on the percentage determined by the rentable square footage on their lease. The owner, on the other hand, is responsible for the expenditures of any vacant space. This is why it’s usually to an owner’s benefit to keep as much of the building rented out as possible.
The way payments are structured depends on the kind of lease a tenant has, as well as any specifications they and owner agree to in the contract. Triple net leases cover base rent only, and any expenditures are assessed pro rata on top of the set rate. Full-service gross lease structures include the building costs in the rate, while a modified gross rent has different inclusions but typically includes some operating expenses in the base rate.
Anyone considering becoming a tenant will often read the operating expense clause in their lease carefully and come back with items they wish to exclude or limit. This could look like negotiating for a higher expense stop, wanting utilities measured or metered rather than automatically assessed, or asking for major expenditures to require their prior approval.
Tenants commonly ask for certain limitations and built-in safety parameters to ensure their charges don’t escalate beyond a reasonable amount. These include expense stops and operating expense caps.
In a gross lease, an expense stop is the maximum annual threshold for building management expenditures that owners are responsible to pay. Though gross leases include these, stops put a limit on what the owner must pay. A tenant in a gross lease may ask for a higher stop if they think the owner should be responsible for more of the management costs. This stop is also used as a numeric reference point on a lease for reasonable charges in the first year of that lease term. Meanwhile, a tenant in a net lease might ask for a lower stop in exchange for the ability to review the landlord’s list of expenditures.
The operating expense cap is a cap on annual expenditures charged to a tenant or a cap on expenditure increases. It is often requested for CAM fees, since owners have the responsibility to hire vendors and source supplies that are billed under CAM charges.
These are just as important as rent. Knowing the price of running a building may help accurately calculate its income potential. No matter the lease structure, operating expenses account for a significant portion of what tenants and owners worry about: the cost of running their business.
Typically, costs such as utilities, repairs, maintenance, exterior work, insurance, management, and property taxes all factor into the overall operating expenses.
Capital expenses, debt service, commercial property marketing costs, leasing commissions, tenant improvement allowances, and capital reserves are typically not included. This may vary from property to property.
In commercial real estate, the operating expense ratio is a measurement of the cost to operate a piece of property compared to the income that property brings to the investor. It can easily be calculated by dividing the property’s operating expenses (not including depreciation) by its gross operating income.
Investors may often confuse operating expenses with direct costs. Both are expenses incurred from operating your business or property, but the operating expenses are not directly tied to production. This only directly affects business owners, rather than investors who own a property, however.
If you’re looking to begin investing in commercial real estate, we can help you get started. Avistone is a rapidly growing commercial real estate investment firm focusing on the acquisition and management of multi-tenant flex/industrial properties and the acquisition and asset management of hotel properties nationwide.
Our firm offers accredited investors the opportunity to purchase equity shares with the potential to receive in-place cash flow from operations and capital appreciation upon sale. In order to provide the best possible outcomes for our investors, we acquire properties in markets with historically high occupancy rates, proven demand, and strong economic indicators.
We also focus on asset and property management to provide superior service to tenants and guests as a key to the success of our investment strategy. Since our founding in 2013, we have acquired 26 properties with more than 4 million square feet of space. Contact us to learn more about our current offerings.
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