By David Eseke, Director
In industrial real estate circles, few topics have generated as much buzz as’ new “clear lease.” In an asset class that is about as simple as they come, from a management and accounting standpoint, Prologis is seeking to further simplify operating expenses and make things easier for tenants.
Essentially, it is an industrial gross lease where, in addition to base rent, the tenant pays a guaranteed amount of its pro-rata share of common area maintenance (CAMs), property insurance, management fees and capital repairs and replacements. The tenant also pays its pro-rata share of property taxes, but that amount is reconciled annually.
With more than 684 million square feet of space under ownership—about the size of the entire city of Richardson—Prologis is the largest landlord in the world. It aims to use its immense scale to both its and its tenants’ advantage. Most tenants feel the pain of operating expenses every year. The landlord’s estimate is typically well below the actual expenses, and tenants have to pay the pauper. Prologis wants to eliminate this annual confrontation and improve the historically adversarial landlord-tenant relationship.
The clear lease strategy also addresses cost-certainty concerns for corporate real estate folks and local division managers. And if the area business leader’s annual bonus is tied the P&L statement, an unforeseen increase in expenses can be a good way to ruin the holidays.
How Does It Work?
In order to guarantee fixed operating expenses, Prologis will assign a capital repair and replacements (CRR) factor, based on the age and condition of each building. (Most landlords don’t quote this number in operating expenses because it varies so much year-to-year.) A newer building will have a lower CRR factor than an older building. Additionally, operating expenses, excluding property taxes, will increase by 2.4% annually. So instead of getting hit with a full truck court repair at $0.25 per square foot, a tenant may only pay $0.06 per square foot for its CRR factor, and it won’t have to worry about a massive variable cost.
Property taxes typically make up 60%-80% of operating expenses. Because taxes are weighted so heavily, you may wonder why those aren’t being guaranteed, too? Particularly in a market like North Texas, where property values (and taxes) have increased so much in recent years.
Like most landlords, Prologis is incentivized to protest their property taxes annually to keep its operating expenses as low as possible. This allows the company to achieve a market “base rent,” which is impactful in the capital markets, should it ever wish to sell any assets. Additionally, property taxes, in general, are much easier to budget for each year, as compared to random variable expenses for capital repairs (hail storms, flooding, snow removal, etc.).
So, how does the leasing agreement change? It gets significantly shorter. Prologis’ standard lease agreement (before all exhibits and addendums) is somewhere close to 20 pages. By simplifying the operating expense language, the new form will be a tidy 11 pages. This will result in quicker lease negotiations and reduced attorney fees.
What About HVAC Maintenance?
Few things are more frustrating for tenants than paying for the replacement of a new HVAC unit. Likewise, few things irk a landlord more than a tenants that don’t properly maintain the equipment. Prologis is addressing this by taking over maintenance of all HVAC units that serve office areas, as well as all warehouse gas heaters. Tenants pay a small amount for this coverage—$0.80 per square foot, per year, for the office space only. So, if you have a 100,000-square-foot space and your office component accounts for 2,000 square feet, you’d pay $1,600 per year. This equates to less than $0.02 per square foot for the entire space.
What Does It Mean Going Forward?
Time will tell if this new lease structure will soften the sometimes contentious landlord-tenant relationship. There will undoubtedly be skeptics who feel that fixed operating expense increases is just another way for a landlord to generate income. However, only an in-depth comparison of operating expenses between multiple landlords would provide any clarity there.
Because Prologis is effectively guaranteeing every lease cost to its tenants, it will be interesting to see if other landlords are willing to do the same. And, it will be more important than ever to compare historical operating expenses between multiple ownership groups to really understand what the actual tenant expenses are. In some cases, I’m sure the “clear lease” will win out, and in others it may not. However, I anticipate strong interest from users in the simplified approach, due to the peace of mind of cost certainty and the shorter lease document.
I applaud Prologis for its efforts to simplify the status quo and change the landlord-tenant dynamic. Using its massive scale as a competitive advantage is good business, even if it underestimates operating expenses by a few cents per square foot. If it means greater occupancy and absorption than the competition, its risk will be rewarded.
David Eseke is a Director within Cushman & Wakefield’s Industrial Tenant Representation group in Dallas.