By Anna Woodworth, Senior Auditor
Many commercial leases include provisions allowing landlords to “gross-up” operating expenses. This means that if the building is not fully occupied, the landlord can bill the expenses to the tenants as if the building is fully occupied. The landlord benefits from a gross-up provision because it shifts some of the costs associated with vacancies to the tenant. The most common gross-up provisions allow for variable expenses (not all expenses) to be grossed-up to 90%, 95%, or 100% occupancy.
The concept of fixed and variable expenses is essential to understanding gross-ups. Fixed expenses are those which do not vary with occupancy, such as real estate taxes, insurance, landscaping, etc. Fixed expenses will cost the same no matter how full the building is. Variable expenses are those costs which do vary with occupancy such as electricity, cleaning, management fees, etc. For example, as the occupancy of a building increases so does the consumption of electricity, resulting in a higher electricity bill.
Further, it’s important to recognize that variable expenses have both fixed and variable components. Cleaning costs are a good example. The janitorial staff will only clean those portions of the building that are occupied, as well as the common areas (the halls, lobby, etc.). If the building was fully occupied, the janitorial staff would clean the entire building. Cleaning of the common area represents the fixed component of the cleaning costs, whereas occupied tenant space represents the variable component of the cleaning cost.
To take this example further, assume Tenant has a 50% pro-rata share of the building premises. Another tenant has 10%, and the rest of the building is unoccupied. The annual cost of janitorial services for the building was $6,000, but if the building was fully occupied, then the janitorial costs would be significantly higher. A side-by-side comparison shows how a gross-up is implemented.
If no gross-up is used, then the landlord will not be reimbursed for 40% of its cleaning bill. If a gross-up with no fixed component is used, then the landlord will recover all its expenses, however the tenants will pay more than their fair share of the common area cleaning. The fairest option for all parties is a gross-up with the applicable fixed component. This way the landlord will recover the fair share of its cost, and the tenants will pay their fair share of the common area as well.
Gross-ups are also practical for tenants. A prime example is a lease with a base year or expense stop. If a tenant negotiates a base year, then, in most cases, the tenant will pay its share each year of the operating expenses which exceed the base year’s expenses. Consider if the building was not fully occupied in the base year and no gross-ups are used: the base year operating expenses will be artificially low. In subsequent years when the building becomes fully occupied, the amount tenant pays will be much higher than if a gross-up had been used in calculating the base year. Gross-ups offer consistency to tenants in leases with base years and expense stops.
Gross-ups can be a confusing part of the commercial lease. Chelepis is here to help tenants understand what gross-ups are and how to negotiate the best result for them throughout the lease term. Contact Chelepis to see how we can be of service.
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