Demystifying Operating Expenses: What Tenants Need to Know Before Signing

Picture this scenario: A successful accounting firm just received their first annual operating expense reconciliation statement. Despite signing what they thought was a straightforward lease, they’re now facing an unexpected $18,000 increase in their annual occupancy costs. The culprit? Operating expenses they didn’t fully understand when they signed their lease.

This scenario plays out more often than you might think.

Operating expenses often represent 10 – 20% of a tenant’s total occupancy costs, yet they’re one of the most misunderstood aspects of commercial leasing. The good news? With the right knowledge and negotiation strategies, you can protect your bottom line from unexpected cost escalations.

Drawing from our 30+ years of exclusive tenant representation experience at Mazirow Commercial, we’ve seen countless businesses get blindsided by operating expense provisions that could have been negotiated differently. The key to avoiding these costly surprises starts with understanding the fundamentals of how operating expenses work.

What Are Operating Expenses?

Operating expenses are the landlord’s costs to operate and maintain the building, which are typically shared among tenants based on their proportionate space usage. Think of it as splitting the household bills in a shared living arrangement—except the stakes are much higher for your business.

These expenses exist because commercial properties require ongoing maintenance, services, and regulatory compliance that benefit all tenants. Rather than incorporating these variable costs into base rent (which would be risky for landlords given their unpredictable nature), most commercial leases separate them as additional rent that reflects actual costs incurred.

Note often Operating Expenses are referred to Common Area Maintenance (CAM) charges.

Categories of Operating Expenses

Controllable Expenses:

Property management fees and administrative costs
Maintenance and repair services
Landscaping, cleaning, and janitorial services
Security services and equipment maintenance
Supplies (toilet Paper! Paper Towels, cleaning solutions/products)

Think of “controllable expenses” as items the Landlord can competitively price

Non-Controllable Expenses:

Property taxes (often the largest component)
Insurance premiums for the building ( a significant variable in todays insurance environment )
Utilities for common areas
Government-mandated building upgrades or assessments

The Critical Capital vs. Operating Distinction:

Operating expenses are day-to-day costs that maintain the building’s current condition
Capital expenditures are major improvements or replacements that extend the building’s life or add value
Gray area items like HVAC system upgrades can fall into either category depending on lease language

Understanding this distinction is crucial because capital expenditures should generally be excluded from operating expenses unless specifically negotiated otherwise.

Calculation Methods and Pro-Rata Shares Explained

Common Lease Structures

Full-Service Gross Leases: In FSG leases, Operating expenses are included in your base rent year 1. All subsequent years of a lease term are compared against the year 1 cost – this is the Base Year. A Full-Service Gross lease is the common lease we see in multi-tenant office buildings.

Triple Net (NNN) Leases: In NNN leases, tenants pay base rent plus their share of all operating expenses. While this structure provides maximum transparency in expense reporting, it also places the highest risk on tenants for cost escalations. You bear the direct impact of every expense increase. Triple Net Leases are common with “flex” and industrial buildings.

Modified Gross Leases: MG leases use a blend of a “base year” methodology (where you pay increases over the first year’s expenses) and direct expenses such as janitorial or electrical or both. Modified Gross Lease are common with medical offices. This structure provides a balanced approach between predictability and cost-sharing.

Pro-Rata Share Calculations

Your pro-rata share determines what percentage of the building’s total operating expenses you’ll pay. This calculation can significantly impact your annual costs, so understanding it is essential.

The formula is straightforward: Your Rentable Square Footage ÷ Building’s Total Rentable Square Footage = Your Pro-Rata Share

Real-World Example:

Your space: 5,000 rentable square feet
Building total: 50,000 rentable square feet
Your pro-rata share: 10%
Year 1 annual building operating expenses: $500,000
Expenses increase by 6% in year two of the lease = $300,000.00 for the year
Under aFSG Lease:
- $300,000.00 x 10% = $30,000.00 for the year or $2500.00 per a month, or $.50/rsf ; in addition to to the base rent.

Under a NNN Lease:

Year 1 you pay $50,000.00 or$4,167.00 per a month, or $.83/rs; in addition to the base rent.

Critical consideration:

Rentable vs. usable square footage: The “load factor” can significantly increase your proportionate share

Essential Tenant Protection Strategies

Expense Categories You Should Exclude

Capital Expenditures That Don’t Belong: unless the cost is amortized over the useful life of the improvement, typically 39 years on a straight-line basis:

Major equipment replacements (new elevators, HVAC systems)
Building improvements that increase property value
Technology upgrades
Structural repairs and renovations

Landlord-Specific Costs to Reject:

Leasing commissions and marketing expenses for attracting new tenants
Legal costs for landlord disputes unrelated to building operations
Financing costs, refinancing fees, and ownership transfer expenses
Ground lease payments or mortgage principal and interest

Inappropriate Charges That Commonly Appear:

Management fees exceeding fair market rates
Costs that should be covered by insurance proceeds
Penalties, late fees, or interest charges incurred by the landlord due to their negligence
Administrative overhead not directly related to building operations

Audit Rights and Control Mechanisms

Annual Audit Provisions: Negotiate the right to examine landlord books and records related to operating expenses. Include a provision requiring the landlord to pay for a professional audit if errors exceed a certain threshold (typically 5% of total expenses). This creates an incentive for accurate reporting while protecting your audit costs.

Expense Controls and Caps:

Controllable expense caps: Limit annual increases to 6% to prevent excessive cost escalations
Management fee limitations: Cap management fees at competitive market rates or a reasonable percentage of total expenses
Administrative cost controls: Establish standards for overhead allocation and exclude excessive administrative charges

Documentation and Transparency Requirements:

Require detailed annual expense statements broken down by category
Demand supporting documentation (receipts, contracts, invoices) upon reasonable request
Establish deadlines for landlord expense reporting and reconciliation
Include dispute resolution procedures with professional mediation options

Negotiation Strategies That Protect Your Investment

Pre-Lease Due Diligence

Historical Expense Analysis: Request 3-5 years of building operating statements before signing any lease. Look for unusual expense spikes, irregular patterns, or categories that seem excessive compared to similar buildings. This historical data is your best predictor of future costs.

Market Benchmarking: Compare the building’s per-square-foot operating expenses to similar properties in your market. In Los Angeles County, property taxes are administered by the County Assessor, Auditor-Controller, and Treasurer and Tax Collector, with funds supporting essential services including public safety, infrastructure, and local government operations. Understanding these baseline costs helps you evaluate whether proposed expenses are reasonable.

Red Flag Identification:

Operating expenses significantly below market rate (suggesting deferred maintenance)
Management fees exceeding 3-5% of total operating expenses
Excessive administrative or professional fees
Capital expenditures disguised as operating expenses

Key Lease Provisions to Negotiate

Gross – UP: Gross-Up Operating Expenses to 95% – to adjust the variable portion of operating expenses – usually those expenses that fluctuate with occupancy – so the Operating expenses are expressed as if the building were 95% occupied, even if the actual occupancy is lower.
Define calculation methodologies clearly to prevent manipulation

Implement Protection Mechanisms:

Negotiate caps on controllable operating expenses (typically 6 %annually)
Require landlord approval for non-emergency repairs exceeding specified dollar thresholds
Establish professional dispute resolution procedures

Key Takeaways

Operating expenses can significantly impact your total occupancy costs, but understanding calculation methods and negotiating proper protections prevents unexpected financial surprises. With the right lease provisions, you can maintain cost predictability while ensuring necessary building services continue.

Immediate Action Items

Review Your Current Situation:

If you’re currently leasing: Review your existing lease operating expense provisions and recent reconciliation statements
If you’re lease shopping: Request historical operating expense data for every building under consideration
For upcoming renewals: Begin preparing your negotiation strategy at least 12 months before lease expiration

Gather Essential Information:

Collect 3-5 years of operating expense statements from prospective buildings
Document any unusual or excessive expenses you’ve experienced in current locations
Research comparable buildings’ expense ratios in your target markets

Professional Guidance That Protects Your Bottom Line

For over three decades, we’ve specialized exclusively in tenant representation, never representing landlords. This conflict-free approach ensures our interests align completely with yours. Our deep expertise in the San Fernando Valley and Conejo Valley markets means we know local expense benchmarks and can identify opportunities for savings that other advisors might miss.

Ready to Protect Your Investment?

Don’t let operating expense surprises impact your bottom line. Contact Mazirow Commercial today for a comprehensive lease review or to discuss your upcoming space needs. Remember, there’s no cost to you—the landlord pays our fee.

Schedule your consultation today:

Phone: (805) 449-1945
Address: 30700 Russell Ranch Road, Suite 250, Westlake Village, CA 91362
Service Area: Los Angeles and Southern California

Take control of your occupancy costs. Your bottom line will thank you.

This article provides general information about commercial lease operating expenses and should not be considered legal advice. Always consult with qualified professionals before making lease decisions.