This post summarizes some basics of “Gross-Up” requirements in dealing with the payment of a building’s operating expenses, i.e. the building that is the subject of a proposed commercial real estate lease. It is common for a commercial lease to require a tenant to pay operating expenses of the building. The payment of those expenses is in addition to the payment of base rent. Landlord pays the expenses and tenant reimburses landlord.
If landlord and tenant have a “triple net lease,” all operating expenses are paid by tenant. The lease may have an expense stop. One expense stop is to agree to a “base year” amount. That amount is expended by Landlord and any sum expended over the base year amount of operating expenses the Tenant pays all or a portion of the excess. Landlord benefits in having a ceiling on variable operating costs. In a building that has more than one tenant, the operating costs will probably be distributed among the building’s tenants. The lease will describe an allocation method for payment of all the expenses or a portion of the total expenses. The allocation uses the tenant’s share of the total area within the building to calculate that tenant’s share of operating expenses. The calculation typically includes the costs of maintaining and repairing (sometimes replacing e.g. HVAC) common areas such as shared conference rooms, washrooms, elevators, escalators, staircases and parking.
Many commercial leases allow the landlord to add the operating expenses together to arrive at a number for the entire building over a one year period or a “gross-up” of those payments by landlord. Landlord grosses-up the expenses as if the building is fully occupied (or another number is used that is less than full occupancy). If the building remains fully occupied during tenant’s entire lease term, the grossed-up language is never applied. The language is applied only if the building is not fully occupied or occupancy falls below a number negotiated between tenant and landlord.
Only certain defined operating costs should be included in the gross-up lease language. As a rule of thumb, a cost is included if it varies by the rate of occupancy of the building. Fixed expenses, which do not vary by occupancy levels, are not grossed-up. Examples of items that vary by occupancy and might be included are electricity, other utilities, trash removal, management fees and janitorial. Operating costs that do not vary by occupancy levels and should not be subject to the gross-up provision include taxes, insurance premiums, and building security.
A landlord benefits by including a gross-up provision in a lease because it shifts some of the responsibility of vacancy to the building tenants. If the building is not fully occupied, the gross-up provision favors landlord to recover a portion of the operating costs paid for the vacant spaces from the existing tenants.
For certain expenses, the gross-up provision is reasonable because the landlord may incur the charges for the entire building, even if it is only partially leased. For instance, if the building does not have separately metered electricity for each unit, the occupied units will require more electricity than the vacant lease spaces. Is it reasonable that existing tenants pay more for electricity usage compared to basing a single tenant’s share of operating expenses only on the space tenant occupies? Negotiations between the parties will answer that question and the answer will also be influenced by the market conditions existing during the lease negotiations.
Gross-up provisions usually only benefit landlords; however, gross-up language may benefit the tenant in limited circumstances. The gross-up provision is important for a tenant that pays operating expenses based on a “base year” amount. After the landlord and tenant agree on the base year, which often is the 12-month period before the lease commencement date or the first day tenant may occupy or must occupy the lease space. In subsequent years, tenant must reimburse landlord for the operating expenses that exceed the base year amount. Tenant has fixed rent until the operating expenses exceed the base year amount.
Without a gross-up provision, if the building is not fully occupied during the base year, the tenant’s expense stop will be low due to the lower occupancy of the building. If the building becomes fully occupied in a later year, the tenant’s proportionate share will be calculated using the increase in operating expenses, which result from increased occupancy of the building. A gross-up provision can state “an agreed-to amount” of variable operating expenses for the base year. An exaggerated amount will protect tenants from a spike in operating expenses in years after the base year.
In negotiating gross-up provisions, tenant will want to make sure it is not responsible for any amount incorrectly grossed-up over the base year amount. To keep the grossed-up provision accurate, the lease can allow tenant to review landlord’s calculations regarding the gross-up to confirm the amount accurately reflects the parties’ agreement. One way is for the lease to allow landlord to gross-up the operating expenses as if a lower occupancy rate existed – say 75%. The negotiated amount could benefit both parties by smoothing the ups and downs each party may experience in the payment of operating expenses.
Whether tenant or landlord, understanding the economics associated with operating expenses will help both parties have a realistic budget showing each party’s share of the operating expenses. Landlords are motivated to have a gross-up provision in a commercial real estate lease, i.e. where the tenants handle payment of all or most of the operating expenses. A well-drafted commercial real estate lease provision about operating expenses can benefit landlord and tenant. Consider the gross-up language in the lease – before it is signed. How can the provision be worded to move you further toward your business goals?
Talk with an attorney at our office. If we can help, you will know at the end of our initial discussion. Either way at Stross Law Firm, P.A., the initial office conference is on us, not you. Contact us at 813-852-6500 or email firstname.lastname@example.org.