Importance of Negotiating Operating Expense Provisions in Health Care Leases

In our ongoing series of blog posts, we will look at several key negotiating points for tenants in triple net health care leases. We will also offer suggestions for certain lease provisions that will protect tenants from overreaching and unfair expenses, overly burdensome obligations, and ambiguous terms with respect to the rights and responsibilities of the parties. These suggestions are intended to result in efficient lease negotiations and favorable lease terms from a tenant’s perspective. This blog post in our series focuses on the negotiation of operating expense provisions.

Many times, health care tenants will enter into “triple net leases,” which place full responsibility on the tenant for payment of all costs relating to the property being leased. When entering into a “triple net lease” for medical office space, health care tenants should pay special attention to negotiating operating expense provisions. These provisions determine which operating expenses the landlord will pass through to the tenant and can have a significant impact on a tenant’s financial responsibility over the term of a lease. Tenants can limit their operating expense obligations by negotiating the following terms (preferably in advance in a letter of intent):

• Carveouts from Operating Expenses: Operating expense clauses generally cover any and all costs of operating, maintaining and repairing the building or center in which the leased premises are located. These clauses are broad and pass through costs for real estate taxes, landlord’s insurance, management fees (which should be limited to 4-5% of total operating expenses for the building), salaries of employees, and maintenance, repairs and replacements to the common areas (including repairs and replacements of sidewalks, parking lots and roofs, and services such as snow removal and janitorial). It is customary for tenants to negotiate that certain items be excluded from the definition of operating expenses. Exclusions tenants should push for include costs relating to marketing and leasing of other space in the building, costs for which the landlord is reimbursed by insurance proceeds or otherwise, legal fees and related expenses arising due to the gross negligence or misconduct of landlord or its agents, fines due to the landlord’s failure to comply with applicable laws, late fees and penalties due to the landlord’s failure to timely pay bills, reserves for future expenses, costs of services furnished to other tenants and not to all tenants of the building (including renovations or alterations for other tenants), costs arising from the potential or actual presence of adverse environmental conditions occurring by reason of the landlord’s or another tenant’s introduction thereof in violation of any applicable environmental laws, costs of correcting defects in the construction of the building, and depreciation, interest and other financing charges.
• Carveouts from Real Estate Taxes: Tenants should also push to include carveouts from the definition of real estate taxes that are passed through to the tenant. Typical exclusions include municipal, state or federal income taxes, interest, late fees and penalties imposed as a result of the landlord’s failure to pay tax bills in a timely manner, inheritance, estate, succession, transfer, franchise, corporation, net income, profit, or capital gains taxes imposed on the landlord in connection with the sale of the property, and any taxes which are determined based upon the landlord’s net income or net worth.
• Controllable Operating Expenses: Since landlords have control over many of the costs that are passed through to tenants as operating expenses, tenants should request an annual cap on controllable operating expenses. These include operating expenses that landlords have control over and typically exclude utilities, snow removal, insurance costs and real estate taxes. These provisions force landlords to run their operations efficiently and not pass poor management costs along to tenants.
• Reconciliation: Tenants should ensure that landlords are obligated to provide estimated statements of each tenant’s proportionate share of operating expenses before the beginning of each calendar year, and to provide actual reconciliation statements within a reasonable time (generally 60-90 days) after the beginning of each subsequent calendar year. Clear language should be included that any underpayments or overpayments will be adjusted between the parties within 30 days of the date of the actual statement, and that any funds due back to the tenant for an overpayment may be credited to the next due and owing base rent or additional rent.
• Sunset Clause: This clause provides that a landlord must invoice a tenant for additional rent (to the extent additional rent is payable through an invoice) within a certain time period (usually 18 – 24 months) of the month in which charges are incurred. This forces a landlord to promptly notify tenants of any additional rent that is not a recurring monthly charge which would be reconciled each calendar year and protects tenants from receiving an invoice for charges that were incurred years prior and for which adequate records may no longer be available.
• Audit Rights: Tenants should always have an express right to audit their landlord’s accounting of operating expenses. It is reasonable for this right to be limited to no more than once per calendar year, to be actionable upon advance written notice to the landlord, to take place within a certain time period of tenant’s receipt of landlord’s year-end reconciliation statement, and to be undertaken by an accounting firm that is not paid on a contingency basis. Any overpayments or underpayments revealed by an audit should be adjusted between the parties. Tenants should push to include language that if the landlord has overcharged tenant by more than a certain percentage (typically 5%) of tenant’s proportionate share of the operating expenses, the landlord will pay the costs of the audit. In all other cases, tenants usually bear the cost of any audits.
• Other Tenant Provisions:
  • Tenants should add language to operating expense provisions to clarify that if any operating expenses passed through to tenant are capital improvements (e.g. replacement of roof), such expenses will be amortized over the useful life of such capital improvements (using generally accepted accounting principles) with the tenant’s obligation limited to the term of the lease.
  • Most times, regardless of whether a landlord passes janitorial costs through to a tenant as part of operating expenses, the removal of medical waste will be a direct cost that tenant is obligated to contract and pay for directly.
  • Tenants should make sure that the cost of improvements necessary to keep the premises or building compliant with laws, including the Americans with Disabilities Act, should be excluded from operating expenses.

Negotiation of any of these provisions is crucial in a “triple net lease” and can have a significant economic impact on a tenant throughout a lease term. As with any highly negotiated lease terms, by addressing these provisions in detail in advance in the letter of intent, the parties can avoid protracted negotiations and can more efficiently negotiate and finalize their leases.

In our next post, we will cover the importance of negotiating assignment and subletting provisions in leases, which are critical for healthcare tenants, particularly with respect to private equity-owned medical practices.

Allison Zangrilli and Zlata Fayer are Senior Counsel in Epstein Becker Green, P.C.’s Health Care and Life Sciences Group. Allison and Zlata have extensive experience drafting and negotiating commercial leases for clients in a wide variety of industries, including healthcare, hospitality, real estate, and professional services. They focus on leases in medical office, retail, and warehouse spaces. They are also experienced in all aspects of real estate matters, including purchases and dispositions, title matters, diligence, and financing.