By Attorney Janet Portman
A net lease starts out just like a gross lease—it too will include a price per square foot. You’ll need to find out whether the landlord has included a rent escalator, as explained in Understanding Gross Leases. The negotiation points mentioned there apply in a net lease situation as well.
A common way to place tax responsibility on the tenant is for the landlord to agree to pay all real property taxes for the first year of the lease (sometimes called the “base year”). Then, after the first year, you pick up all or a portion of any increase.
Example: Spartan Enterprises leases a small building from Urban Developers for five years. The lease says that in years two through five of the lease, Spartan will pay 50% of any increase in real property taxes beyond the first year amount. Taxes are $3,000 for year one and are paid entirely by Urban. In year two taxes, taxes go up to $3,300. Spartan owes $150 in real property taxes in year two (50% of the $300 increase). Urban pays the remaining $3,150.
A landlord may, however, ask you to pay for more than just the tax increases. You could be asked to pay for all real property taxes, or to split real property taxes 50/50 with the landlord. A strong landlord may also set the base year several years in the past, when the tax bill was lower than it is now, so that you immediately begin paying the increase.
If you’re going to pay all or a part of the landlord’s real property taxes, it’s important that the lease clause specify that you’ll pay according to your percentage of the property’s total rentable space—not the space that happens to be rented when you sign your lease. If you pay according to the total space that happens to be rented at the time, you can end up paying an enormous portion of the tax bill if there are significant vacancies in the building. The following example illustrates the problem.
Example: California Sew and Vac rented 2,000 square feet of the total rentable area of 10,000 square feet in Larry Landlord’s building. Sadly for Larry, only half of the total space (5,000 square feet) is actually rented out. Sew and Vac has a net lease that obligates it to pay for a portion of Larry’s property taxes. There are two ways to compute the portion:
According to the rented space. Larry Landlord would like the calculation to be the result of dividing the amount of space leased by Sew and Vac by the amount of space actually leased in the building, or 2,000 divided by 5,000. Sew and Vac’s portion of the taxes would be 40%. The other tenant (or tenants) pay 3,000 divided by 5,000, or 60% of the bill. The tenants together pay 100% of the tax and Larry pays nothing.
According to the rentable space. Sew and Vac would like the calculation to be the result of dividing the space it leases by the total rentable area, or 2,000 divided by 10,000. Using this method, Sew and Vac’s tax obligation would be 20%. The remaining tenant (or tenants) will pay 30% (3,000 divided by 10,000). The tenants together pay 50% and Larry Landlord pays 50% of the tax bill.
You can see why a landlord would prefer to base your tax responsibility on the rented, not rentable, area of the building. Under the first system, the landlord will pass the risk of an empty building onto the tenants—whoever is there will divide the bill among themselves. Under the second system, however, the landlord will pay taxes for the unrented space.
If you see (or expect) significant chunks of vacant space in the building, try hard for a lease clause that bases your share of taxes on the building’s rentable space. If it’s a hot property with vacancies unlikely and apportionment is based on rented space, you won’t have much to worry about.
When you negotiate the lease, ask to see the landlord’s property tax bill for the preceding year. If you’re asked to pay all or a portion, you’ll know the amount—for now. But it’s not likely to remain static. The tax amount may rise because:
The building is reassessed. It pays to find out when the tax figure was last adjusted for the property (this information is available from the local tax assessor). If it was recently changed, chances are that you won’t see a change in the near future. But if the taxes have remained the same for several years, and especially if property values in the neighborhood have -increased or the landlord has improved your building, a tax increase may be in store. Be prepared.
The building is sold. If real estate values increase substantially and the landlord sells the property for a handsome sum, the real estate taxes will probably go up. The fact that the new owner must honor your lease will be cold comfort when you get a monstrous tax bill for your share of the increase.
For these reasons, it’s great if you can get a binding promise that you’ll be excused from paying taxes over a stated amount. This will protect you from additional taxes if a reassessment or building sale results in higher taxes.
This article was excerpted from Negotiate the Best Lease for Your Business by Janet Portman