WASHINGTON, DC—The General Services Administration has used an unexpected tactic to avoid paying operating cost increases to REITS, commercial developers and other commercial landlords that lease real property to the federal government.

Imagine you are at the tail end of a long term lease. The lease includes an operating cost escalation clause to cover the cost increases in the Consumer Price Index over the life of the lease. During negotiations over a lease extension or renewal, GSA conveniently omits any discussion of resetting the base, against which those cost increases have been measured historically.

The language of the extension specifically says that the annual rent shall continue to be adjusted for operating cost escalations as provided in the Lease using the same operating cost base established during the initial term of the Lease and all other terms and conditions of the lease will remain in effect. But when the first payment comes due, GSA pays you only a fraction of the accrued operating cost escalations. When you ask why, GSA claims that you are not entitled to accrued CPI, but only the marginal year over year increase in operating costs per GSA policy and that your new annual rate of rent should have factored for those costs. It is a trap for the unsuspecting lessor, but luckily it can be avoided through awareness and careful negotiation.

In a string of recent federal cases, the GSA has attempted to argue that commercial lessors are not entitled to be paid in lease extensions and renewals for their operating cost or CPI increases that accrued during the original lease term. On multiple occasions, GSA has argued that the lessor is not entitled to the difference between the original operating cost base (which is often ten or more years old) and the change in the CPI. Instead, GSA claims that the lessor is only entitled to the marginal change from the last lease year and the current renewal year.

There is no mention of such a policy in the Federal Acquisition Regulation, GSA Acquisition Manual, GSA's Leasing Desk Guide or any published GSA policy that supports GSA's attempt to shirk full payment of operating costs. But lessors must be careful not to unwittingly negotiate its rights to full payment in either the extension or in ongoing lease supplemental amendments.

To put this issue in context, GSA leases include operating costs (for example, the cost of cleaning services, supplies, materials, maintenance, trash removal, landscaping, water, sewer charges, heating, electricity and certain administrative expenses attributable to occupancy) that will rise year after year. The typical GSA lease includes a clause that determines whether the rental rate remains firm throughout the term of the lease, or if the rent is subject to an annual re-adjustment of operating costs. The amount of adjustment is determined by multiplying the operating costs in the base year by the percent of change in the CPI in the anniversary year (e.g., the second, third, fourth year). The costs listed on GSA Form 1217 (Lessor's Annual Cost Statement) are used to set the base rate for the operating costs adjustment. The 1217 is negotiated and agreed upon by GSA and the lessor at the beginning of the lease. The CPI is measured by the Department of Labor and published by the Bureau of Labor Statistics.

The lease clause should include a simple mathematical formula. You multiply the operating cost base by the percentage change in the published Consumer Price Index between the base and anniversary years to determine the precise amount due for each year. For example, let's assume the first year of a lease with a ten-year term began on Jan. 1, 2015. No operating cost increases are paid in the first year 2015. According to the Form 1217, the operating cost base is $1,000,000. To calculate the amount of operating cost escalations GSA is required to pay in the second year (i.e., the first anniversary) requires a two-step process.

First, calculate the difference between the Consumer Price Index in the base year and the anniversary year:

Base CPI January 2015 233.707

Anniversary CPI January 2016 236.916

The difference between 233.707 and 236.916 is 3.209 or about a 1.4% increase (0.013730868 to be precise).

Second, plug the numbers into the operating cost escalation formula as follows:

Base Operating Cost Per Lease $1,000,000.00

% Increase in CPI x 0.013730868

Annual Increase in Operating Costs $ 13,730.87

This amount is relatively small in the first anniversary year. However, it will likely be much larger by the tenth (and final) year of the lease term. Typically, operating cost escalations are divided by twelve and made part of the monthly rent payments.

While the calculation is relatively straightforward, lessors need to be vigilant because GSA often tracks the operating cost escalations in terms of year over year increases – not base year versus anniversary year outlined above. In those instances, GSA runs the operating cost escalation calculation per the operating cost escalation clause in the lease, but then GSA deducts what it paid for cost escalations the previous year. Often, GSA asks the lessor to sign a lease amendment to acknowledge the increase in annual rent inclusive of real estate tax and CPI increases. There is no regulation or published guidance (such as the GSA Leasing Desk Guide) to support this methodology. Presumably, GSA does this to make it easier to identify the amount that the rent will increase from the last year. The risk for lessors is that GSA's methodology differs from the plain language of the lease. If the landlord signs a modification incorporating GSA's faulty math, it could change the terms of the lease and affect the amount of rent, to which the lessor is entitled in the future.

This issue arises every time GSA either extends or renews a lease. Historically, GSA continued to pay operating costs increases based on the operating cost base in the original lease or requested that the operating cost base be reset. If the operating cost base is reset, the costs are listed on GSA Form 1217 (Lessor's Annual Cost Statement), which is used to reset the base rate for the operating costs adjustment for the extension or renewal. Just as with the original lease, the 1217 is negotiated and agreed upon by GSA and the lessor at the beginning of the extension.

A recent example of GSA's attempt to claw back CPI increases can be found in Appeal of 1201 Eye Street, N.W. Associates, LLC vs. General Services Administration, CBCA No. 5150, where GSA unsuccessfully argued that ten years of accumulated operating costs did not carry over to a five-year lease extension. Ultimately, the Civilian Board of Contract Appeals (awarded more than $2 million in unpaid operating cost escalations for a REIT on the National Park Service headquarters in Washington, DC.

In that case, GSA added two extra steps to its annual calculation of the amounts owed in a ten-year lease. First, after calculating the operating cost adjustment for the year, GSA subtracted an amount it labeled “previous escalation paid,” which was the operating cost for the previous year, from the current year's adjustment. GSA labeled that amount “annual increase in operating cost due lessor.” GSA then added that incremental amount to the total annual rent amount calculated for the previous year to derive the new annual rent for the current year.

Base Operating Cost Per Lease $1,326,720.00

% Increase in CPI x 0.084611016

Annual Increase in Operating Costs $ 112,255.13

Less Previous Escalation Paid $ 66,298.33

Annual Increase in Operating Cost Due Lessor $ 45,956.80

There was nothing in the lease that required the last two steps and no formal GSA policy to support this methodology. The lessor also wisely never signed the lease amendments, which contained these calculations.

After the lease expired, GSA entered into a period of holdover for two years. After NPS decided it would move its personnel to the Department of Interior building, NPS asked GSA to negotiate a five-year extension. The lease extension stated that “[t]he new annual rent shall continue to be adjusted for operating cost escalations as provided in the Lease using the same operating cost base established during the initial term of the Lease (i.e., CPI increases are due July 16, 2012…).” The extension also said that “[a]ll other terms and conditions of the lease shall remain in force and effect.”

GSA continued to calculate the CPI increases the same way with one notable exception. Rather than adding the annual increase in operating costs to the previous total annual rent paid in the previous year as GSA had done during the original ten year lease to capture the previous operating cost increases, GSA added the much smaller, year over year increase to the new base annual rent as agreed by the parties in the extension. The obvious result was that GSA was no longer paying the previous cost adjustments (or so-called “accrued CPI”). GSA calculated a total rent amount that paid only the increase in operating cost adjustments from the prior year (2011) instead of the operating cost adjustment increase from the base year (2002).

The CBCA rejected GSA's argument that the lessor was not entitled to accrued CPI. Judge Sullivan found that argument was inconsistent with the plain language of the lease, which explained the calculations required to compute the annual rent and adjustment for operating costs, and nothing in the lease extension changed that methodology.

A similar argument is currently pending before the CBCA. In Belle Isle Investment Company L.P. vs. General Services Administration, 16-1 BCA 36416, the board recently denied cross-motions for summary relief. The question in that case will turn on whether the lessor agreed in the renewal to include accrued CPI in the new annual rent.

REITs, commercial developers and other commercial landlords that lease real property to the federal government can avoid falling into this trap by taking a few simple measures:

First, don't let GSA include in lease amendments or supplemental lease agreements calculations for the CPI increases that differ from the method set forth in the lease.

Second, if GSA insists on showing the year over year increases on lease amendments, don't sign them.

Third, include an express written reservation of rights on any renewal or extension that expressly states that the lessor is entitled to be paid its aggregated operating cost increases in addition to language such as “the annual rent shall continue to be adjusted for operating cost escalations as provided in the Lease using the same operating cost base established during the initial term of the Lease” and “all other terms and conditions of the lease will remain in effect.”

Fourth, consider resetting the operating cost base if you have concerns.

Reginald M. Jones is the chair of Fox Rothschild LLP's federal government contracts practice and represented 1201 Eye Street, N.W. Associates LLC in the case against the GSA. He is based in Washington, DC. The views expressed here are the author's own.

Instant Insights /

There's No Such Thing as 'Accrued CPI' in GSA Leasing

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