You may be paying more than you owe
As the industrial real estate market continues to enjoy historically high rents and building valuations, landlords are reaping the benefits in the form of increased profits. That said, there are several other areas where landlords have been able to line their pockets, often at the expense of unsuspecting tenants.
In order to understand how much extra money may be flowing into your landlord’s coffers, let’s take a look at three of the most common hidden profit centers:
- Management fees
- Capital expenses and
- Selling maintenance contracts.
Profit Center #1: Management fees
In a net lease, virtually all maintenance expenses are borne by the tenant. In many of these leases, the maintenance costs (also called CAM charges or operating expenses) are “passed through” to the tenant. This means the landlord or management company will contract, coordinate, and pay for the building maintenance, and then pass those costs to the tenant as a line item on the monthly rent statement.
A component of that maintenance charge will often include a management fee. Although one could reasonably argue that there are administrative costs associated with managing a building, these fees often far exceed the actual costs.
How are management fees calculated?
Management fees are usually calculated as a percentage of net rent. However, the justification for this calculation is questionable; the cost to manage a building usually has nothing to do with the amount of rent that is collected.
Because net rent is calculated on a square foot basis, as the size of the building increases, so do the management fees.
Let’s compare two buildings.
One building is 200,000 square feet.
The other is 1 million square feet.
Both buildings are single-tenant buildings and the administrative costs are limited to contracting to have the grass mowed, the snow plowed, and having small repairs made to parking lots or walkways.
The management fee for the 1 million square foot building costs FIVE TIMES as much as the 200,000 square foot building.
Clearly, it doesn’t cost the five times more to manage the larger building—so this is pure profit to the landlord.
We mentioned in our last blog that many institutional landlords are moving toward gross lease forms. Because the majority of these buildings are professionally managed there will likely be an expense line item for management fees.
Gross leases frequently have annual escalators, which means that the management fee and all maintenance costs will increase every year. So, whether or not expenses increase, the fee will increase.
Profit Center #2: Capital Expenses
Some landlords attempt to pass unreasonable capital building expenses onto tenants: read more about this in The Roof and Structure Clause. Even worse, some landlords may try to pass the cost of capital repairs that occurred before you leased the building.
For example, let’s say a landlord replaced the parking lot in 2015 for $500,000. In 2017 you lease that building. It will be important to understand the breakdown of maintenance costs to ensure that no charges to cover the parking lot replacement are included in the 2017 maintenance expense charge.
When you lease a building, it is presupposed that the rent pays for basic elements, such as four walls, a roof, a floor, and a parking lot. Paying for a parking lot that was replaced before you became a tenant is unreasonable.
It is critical that you dig into all the costs that make up the passed-through maintenance expenses before you sign a lease!
Paying for a parking lot that was replaced before you became a tenant is unreasonable.
Profit Center #3: Management contracts.
The last and most valuable profit center is selling building management rights to a professional management company.
Why are these contracts so valuable?
These management contracts are highly lucrative for both parties.
Landlords can effectively sell contracts to manage the buildings they own. In fact, the more egregious fees and questionable cost allocations that the landlord can hide within maintenance charges, the more profitable they become.
The management companies that are assigned these contracts can profit by reaping the benefits of those hidden fees.
When you consider that management contracts regularly being assigned are valued in the tens of millions of dollars, it becomes clear that there is more being “passed through” to tenants than just the cost to mow the lawn.
Landlords have a handful a tactics they can utilize to extract hidden profits from tenants. They may use their size and power to intimidate the tenant or be less than transparent during negotiations.
Protect yourself by taking these three actions:
- Become very familiar with the management fees and understand where they come from
- Request an itemized list of all current maintenance expenses. Without this list, determining exactly what you are paying for will be very difficult and
- Be vigilant about specifically defining what can and cannot be passed through as a maintenance expense.