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Retail vs. office leases

Last month, we worked on a beautiful, relatively new lifestyle retail property in California. It was developed by company that traditionally develops office. We did not know that they were office developers when we started the project. It became obvious after abstracting the first two leases.

How could it be obvious by reading lease? By seeing three of the primary differences between retail and office leases. Typically, in retail, tenants pay a full prorata share of expenses. In office, tenants will often pay a prorata share of the increase in expenses over base year expenses. Second, in retail, the leasable area of the premises (and the property) is typically used for all calculations while in office, distinctions are made between the rentable and usable areas (with rentable including a common area factor applied onto the usable). Finally, to minimize the absorption of expenses due to vacancy, retail will bill based upon the “leased” area of the property (leasable less vacancies) while in office, we “gross up” expenses to what they would be if the property were fully leased (or leased to some other level).

Personally, I prefer retail leases. To me, the calculations always seem absolute. If the property has $1,000,000 of recoverable expenses, the tenants will pay their full share of the $1m. In office, they pay excess over their base year. Therefore, the excess amounts will vary from tenant to tenant. And, if a tenant audits, it almost becomes necessary to audit the current year and the base year to determine the proper excess. Related to square footage, in retail, once a premises has been measured as 1,000 square feet of leasable area, it will always be 1,000 square feet. However, in office, a premises that has been measured as 1,000 square feet of usable area will have a rentable area that will vary over time based upon the then-current common area factor of the property.  A 10% common area factor would make for an 1,100 sf rentable area, while a 20% common area factor would make that same space 1,200 square feet of rentable area.

And, finally, in office, we gross up the variable expenses. If we are at 80% occupied, we determine what expenses would be if we were at 100% (or some other negotiated percentage) occupied. Some calculations are simple math. 100/80 x the expense. Others are determined by contract. An elevator contract is $x if we are at 80% occupied and $y if we are at 100% occupied. Others are more subjective. Would we have to add another day porter if we went from 80% to 100% occupied? Still others can be argued endlessly. Do we gross up taxes – possibly if we are in a municipality where the assessments are determined by an income approach and they factor in vacancies. But, we do not get to gross up expenses that are not variable. We end up with some degree of absorption. But, in retail, billing based upon leased, we essentially get to “gross up” (algebraically) all the expenses based upon that simple math. All expenses – fixed and variable.

You can always find retail-type clauses in office leases and vice versa, but when you see those concepts above, you will know where they came from.

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