Question 1

What is operating expense escalation in a commercial lease?

Accepted Answer

Operating expense escalation is a provision in a commercial lease that allows the landlord to pass through increases in operating expenses to the tenant. The escalation can be structured as: a fixed escalation (rent increases by a fixed percentage each year, regardless of actual expense changes), a CPI-based escalation (rent increases based on the Consumer Price Index), or a pass-through escalation (the tenant pays their pro rata share of the actual increase in operating expenses over a base year amount).

Question 2

How does a base year operating expense escalation work?

Accepted Answer

Base year structure: the first year of the lease is the "base year." The landlord pays all operating expenses during the base year. In subsequent years: the tenant pays their pro rata share of any increase in operating expenses above the base year amount. Example: base year operating expenses: $0 per square foot, year 2 operating expenses: $1 per square foot, increase: $ per square foot, tenant’s pro rata share: 10% of the building, and tenant’s escalation payment: $0.10 per square foot per year (or $ x 10%). The base year approach: protects the tenant from the first year’s expenses (which are included in the base rent) and ensures the tenant only pays for increases.

Question 3

What expenses are typically included in operating expense escalations?

Accepted Answer

Included expenses: property taxes, property insurance, common area maintenance (CAM: cleaning, landscaping, parking lot maintenance), utilities (common area electricity, water, sewer), management fees (typically 3-5% of gross revenue), repairs and maintenance (HVAC, elevators, roof, exterior), and security. Excluded expenses (typically negotiated): capital improvements (major building improvements are usually excluded or amortized), leasing commissions, tenant improvement costs, depreciation, debt service (mortgage payments), and above-standard landlord expenses (expenses caused by a specific tenant’s requirements).

Operating Expense Escalation

Operating Expense Escalation in Commercial Leases

Escalation Types

Base Year Structure

Included/Excluded

Related Terms

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