Impacts of financial decisions
Four Tips for Choosing Nonprofit Office Space
Editor’s note: I recently met with my friend Pat Gioffre, former chief operating officer for the National Rural Electric Cooperative Association (NRECA). Pat is now sharing lessons learned managing NRECA’s real estate needs as a senior vice president for his clients at The Ezra Company. These insights resonated with me based on my experience working with CLA’s clients and I wanted to share them with you.
John P. Langan, CPA, Chief Industry Officer, Public Sector
Choosing office space for your organization is an important decision, whether you are establishing your first location, moving to a new one, or opening an affiliate. The space you choose must support your mission and help accomplish your goals.
Every nonprofit has its own parameters for where to locate an office. These may include access to:
- Talented staff
- Federal, state, or local governments
- Regulatory agencies
- Public transportation
- Major highways
These are all valid considerations, but I’d like to look at four items that don’t often get the attention they need when making these important decisions.
1. Look beyond occupancy costs
The occupancy costs of office space are always a factor, but they may not be the driving factor in your decision. Other costs, such as unemployment taxes, sales and use tax, personal property tax, and the cost of parking, should also be reviewed. There is a significant difference in these costs from state to state.
For example, in Washington, D.C., rental rates will be approximately $10 per square foot higher than in Virginia and Maryland. Parking will be more than $200 per month per space higher and taxes are higher in our nation’s capital. Some organizations that need a presence in Washington maintain a small office in the district, with the majority of staff in neighboring Virginia or Maryland.
This model can save a significant amount of money and should be considered if the majority of your organization’s staff does not need to be in the more expensive location.
2. Consider owning rather than leasing
Recent economic and real estate market conditions have resulted in attractive long-term financing options. Very high vacancy rates in some areas of the country have caused real estate values to drop. Combine low values with low interest rates, and you can see why this may be an ideal time to buy.
Many nonprofits don’t even consider an option to purchase their office space. If your organization is stable and you have the necessary cash to consider a purchase option, conduct a lease-versus-purchase financial analysis to determine the best economic option.
Landlords may even be willing to sell floors in their buildings, rather than the whole structure. In the past, unless you were willing to take the rental risk for space that you were not occupying, you had only one option: purchase a small building. Many of those buildings were old and in need of major renovations. With the current high vacancy rate in some of the major metropolitan areas, many landlords are now willing to sell full or partial floors in Class A office buildings. This allows you to purchase only what you need without taking the rental risks of excess space.
Some developers and landlords are willing to build condo office buildings or convert existing buildings that are substantially vacant to a condo office building with shared facilities like meeting rooms, mail rooms, and duplicating centers.
Shared facilities result in lower space requirements. A condo office building will also give you a representative on the condo board, so you can help make decisions such as selecting a management company. Unlike leasing, ownership allows your organization to accumulate equity. If you are able to lock in a long-term fixed interest rate, you will know your occupancy costs for the term of the loan, and at some point, ownership will become less expensive on an actual cash basis.
3. Be aware of operating expense provisions
Many leases have a provision that allows the landlord to pass back its pro rata increase in operating expenses to the tenant. If the tenant occupies 10 percent of the building, the landlord can pass back 10 percent of all increases in operating expenses over a base year (i.e., usually the initial rental year). Operating expenses are things like real estate taxes, insurance, and common area maintenance expenses that the landlord incurs to maintain the building, including:
- Janitorial services
- Gas, water, and electricity utilities
- Repairs and maintenance to all of the building systems like elevators, heating, ventilating, and air conditioning (HVAC) systems, and electrical and plumbing
- Property management fees
- Reimbursement for labor
Operating expense provisions are often lengthy and include complex mathematical formulas and highly detailed definitions that run for pages. Consequently, they may not always receive the focus, understanding, and negotiation that are warranted in light of the potential impact. Most real estate agents don’t have a comprehensive understanding of these provisions, so they are generally not negotiated very well, if at all. The result is that the tenant pays a significant amount more than necessary over the term of the lease.
Here’s an example: If the base year is understated by $1 per square foot in favor of the landlord on a 10,000 square foot lease for a 10-year term, this item alone would cost the tenant more than $100,000 over the term of the lease. It is the landlord’s goal to keep the base-year expenses as low as possible in order to pass more operating expenses to tenants.
In a new building, equipment like elevators and HVAC systems are under warranty for the first year. But if the first year is also the base year in the lease, then the base-year operating expenses could be understated because of the warranties. If the operating expense provision does not specifically state that the base-year expenses should be increased for the value of the warranties, then the tenant will likely pay for the impact of these warranties for the entire term of the lease.
Your initial reaction is probably that this is not fair, but if the lease does not specifically address adjusting the base-year operating expenses for items such as warranties, then the landlord will most likely not make those adjustments.
4. Look for the “gross up” clause
Another area that could have a significant economic impact if not properly addressed in the lease is the “gross up” clause. Grossing up expenses is a method of extrapolating certain expenses that vary based on occupancy. If the building is not fully leased, the tenant’s proportionate share of the expenses accurately reflects the expectation of the parties. For example, if the building is only 50 percent occupied during the base year, then operating expenses for items such as janitorial services will be significantly less than if the building was fully occupied.
For the purpose of calculating the operating expenses for the base year, the expenses for janitorial services should be increased as if the building was fully occupied. If this is not done correctly, resulting in the operating expenses for the base year to be understated, then expenses passed to the tenant for the entire term of the lease will be overstated.
Another area that could have a significant economic impact is repairs and maintenance associated with a parking garage. When a landlord charges a parking fee in addition to rent, any cost attributable to the operation of the parking garage should not be included in operating expenses. Again, if this is not specifically addressed in the lease, then most likely the landlord will pass these expenses to the tenant.
Ask for help
Be sure you hire real estate, legal, and financial professionals who are capable of negotiating the complicated provisions throughout your office space lease. By taking steps to ensure you are getting the most for your organization’s dollars, you are helping to support your important mission.