Escalation income usually represents a significant portion of an office building’s revenue. That means owners should take the time to ensure they’re collecting as much of the income as possible.
Reduce billing errors
It’s not uncommon for tenants’ escalation invoices to have errors, generally because the escalation method applied doesn’t correspond with the method specified in the respective leases.
Escalation methods include:
- Base year with “gross up,” where the tenant pays a portion of the expenses incurred beyond those incurred in a “base year,” with the expenses adjusted to reflect the costs as if the building were fully occupied;
- Expense stop, where the owner’s expenses are capped; and
- Stipulated base amount, a hybrid of the two previous methods.
Applying the wrong method (or the right method improperly) can lead to escalation income “leakage,” or expenses that are reimbursable by tenants but nonetheless not recovered.
Smaller companies might lack the internal resources to properly make the calculations, relying instead on spreadsheet formulas that can be out of date or fail to account for differences between individual leases. Larger owners could run into problems if they use software packages that don’t include the applicable methodologies. Both types of owners should institute measures to ensure their calculations reflect the appropriate formulas — for example, by obtaining better software or outsourcing the billing function.
Review and restructure your leases
Your lease terms could help mitigate leakage. For example, if your leases all end on the same dates, you might end up on the hook for a larger percentage of operation expenses than anticipated if several tenants opt not to renew. Try to stagger lease expirations. At the very least, carefully track when your leases will expire so you’re not caught unprepared. You may, for example, be able to incentivize tenants to add time to their lease terms.
Watch your capital amortizations
Operating expenses aren’t the only costs that can suffer from leakage. Amortizations of capital expenditures can have similar issues. For example, tenants are generally willing to agree to pay interest on new capital expenditures as a way to reduce operating costs — but owners frequently fail to actually charge their tenants interest on escalatable capital expenditures. As a result, the owners miss out on earning a return on their capital investments.
An ongoing challenge
In a multitenant building, you’ll likely never recapture all of your expenses through escalation clauses, as vacancies, lease expirations, and similar factors make it virtually impossible. Taking the steps discussed, though, can help you recover many of those expenses.
For more information contact your MarksNelson professional.
About the author
Sarah Schiltz specializes in Consulting, Tax, and Accounting services for Real Estate, Healthcare, and High Net Worth Clients. She focuses on working with them to provide responsive and accurate tax, accounting, and planning services which allows them to grow and sustain their company.