In an uncertain economy, commercial landlords understandably look for ways to protect themselves from financial exposure. One approach is the inclusion of gross-up provisions in leases. A properly drafted gross-up provision can help ensure that tenants pay their share for operating expenses when some units are vacant, while also protecting tenants from unexpected cost increases.
Commercial landlords of multitenant properties typically require tenants to pay — in addition to rent — their share of the property’s operating expenses, including taxes, insurance, utilities, maintenance and trash removal. Each tenant’s share is generally based on the percentage of the property’s total rentable square footage it occupies. If a property isn’t fully leased, the landlord ends up carrying the burden of the operating expenses allocated to the vacancies.
But the operating expenses will usually be much higher for the occupied units than the unoccupied. Unoccupied units, for example, use few utilities, may not require janitorial services and don’t generate trash. As a result, the landlord will be subsidizing some of the tenants’ operating expenses — because the tenants continue to pay based on their square footage, rather than on their actual variable expenses.
A gross-up provision permits a landlord to calculate and allocate operating expenses as if the property were fully occupied. Essentially, the landlord will “gross-up,” or overstate, the operating expenses that vary depending on occupancy (for example, utilities) to reflect full or almost full occupancy; the most common standards are 95% or 100% occupancy. Each tenant’s share will be based on the grossed-up expenses.
For example, a fully occupied property has $17,000 in variable expenses and $3,000 in fixed expenses, for a total of $20,000 in operating expenses. A tenant that occupies 10% of the property will pay operating expenses of $2,000 (and the landlord pays none of the expenses).
What if the building is vacant except for that tenant, and the variable expenses fall to only $2,000? The total expenses will be $5,000 ($2,000 plus $3,000). Without a gross-up provision, the tenant’s share would be only $500 (10% of $5,000), despite the fact that it incurred all of the variable expenses — leaving the landlord to pay $4,500 in operating expenses.
With a gross-up of variable expenses to 100% (or $17,000), though, the total expenses would be $20,000 — as if it were fully occupied — and the tenant would pay $2,000 (all of its variable expenses). The landlord would still pay $3,000 but would save $1,500, compared to the lease without the gross-up provision.
On the flip side, gross-up provisions can protect tenants from fluctuations in operating expenses over the course of their leases, especially if a tenant pays operating expenses according to a base year amount. Once the parties agree on the base year (usually the first year of the term), the landlord charges the tenant based on the annual operating expenses that exceed that threshold.
If the property isn’t fully occupied the first year and the lease doesn’t include a gross-up provision, base-year expenses will be relatively low. If the property subsequently fills up, the tenant’s share will be based on the higher operating expenses that come with full occupancy. By contrast, a gross-up provision would allow the landlord to gross-up the variable operating expenses for the base year, so, going forward, the baseline threshold for operating expenses would be higher and the tenant’s share would be smaller.
A carefully drafted gross-up provision can be advantageous for both landlords and tenants. The landlord spreads around some of the costs associated with vacancies, and the tenant avoids dramatic jumps in operating expense charges.
Contact a member of your service team for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.
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