For years the District of Columbia's Office of Tax and Revenue fought giving proper consideration to tenant concessions, leasing commissions and capital improvements when determining an office building's net operating income (NOI). The District contended that if those expenditures were considered in full at the time they were expended, such consideration would skew an analysis of an office building's future income stream.
To avoid this lump sum problem, property owners determined that one should amortize these costs over the life of the lease, or in the case of a capital improvement, over its useful life. The District opposed amortization because after the initial period of free rent was over, all of these costs had been fully expended; the free rent had "burned off," the build-out was complete and paid for, and the leasing agent had been paid.
Once spent, D.C. contended that those expenditures would not have been considered by a new purchaser in evaluating the future income stream. However, this analysis ignored that an investor would assume that, at the end of each lease, the old tenant might vacate. Thus, the landlord would have to offer more free rent to attract a new tenant, pay to remove the old build-out and replace it with a new one, and pay a leasing agent to find a new tenant. Given this continuous cycle, it was appropriate to amortize the leasing commissions, free rent and tenant build-out that applied to each lease. Even if a tenant remained, he would typically negotiate for new concessions or, instead, a lower market rent.
Tenant concessions Before the mid-1980s, landlords paid for only basic or "standard" build-out (walls, doors, carpets, etc.). During the office building "over-boom" of the mid-1980s, office building owners were required to offer free rent and an increased "above-standard" build-out allowance to attract tenants. At the same time, landlords could maintain the myth of a high face rent that lenders seemed to desire.
The District now accepts reality and considers it appropriate to amortize the above costs in computing a stabilized NOI. Indeed, each D.C. office-building owner is required to report both contract rent and net effective rent. Net effective rent is contract rent minus tenant concessions (free rent, above-standard build-out, moving allowances, etc.) amortized over the life of the lease. Using these net effective rates produces an adjusted gross potential income that accounts for the practical impact of these concessions. Leasing commissions, improvements
The District was also leery of considering leasing commissions or capital improvements as expenses when determining a stabilized NOI for the same reasons it initially opposed tenant concessions. The District has now accepted that leasing commissions and capital expenditures are recurring costs, and allows them to be considered on an amortized basis.
While major capital expenditures are different than prior landlord expenses because they are unrelated to any specific lease, those expenditures should still be amortized, but over the useful life of the capital improvement rather than over any specific lease term. Significantly, these new capital improvements are related to the total lease structure as they help attract and hold tenants, and protect the office building's stabilized income stream.
Recordkeeping Careful recordkeeping is the key to implementing all amortization possibilities. The property manager should keep a history and details of all leasing commissions, tenant concessions and capital improvements. Too often office building owners lose legitimate adjustments of their income and expenses by sloppy recordkeeping.
For example, tenant concessions, leasing commissions or capital improvements are considered for the first year or two after they are generated, and then inadvertently forgotten in subsequent years. To keep the historical thread intact, buyers should always request that sellers provide these records at settlement. Unfortunately, this seldom happens.
The bottom line The careful amortization of tenant concessions, leasing commissions and major capital expenditures can significantly reduce an office building's NOI, and hence the assessed value and real property taxes. Although proper recordkeeping and filing of government or private forms using amortization of these expenses can be time consuming, such procedures can significantly lower property tax bills.
In summary, the expenditures discussed represent reductions in cash flow for the landlord and they should not be overlooked when evaluating an office building's value for tax appeal purposes.