In the cyclical world of real estate investment, property owners and their lenders have long sought ways to minimize their financial exposure as vacancy rates rise and fall. If left unaddressed, vacancy volatility undermines the ability of a landlord to pass through operating expenses to its tenants, and can whipsaw a tenant when operating expenses swing wildly from year to year.
To solve this problem, commercial leasestypically include a “gross-up” provision, which allows a landlord to project operating costs for a building with significant vacancy as if it were fully occupied. For tenants, any provision granting the landlord broad authority to estimate operating expenses not only seems to be against the tenant's best interest, it gives the appearance of “gross” unfairness.
Yet, property owners, and their tenants, should demand its inclusion in every commercial lease.
Providing Cost Certainty
The utility of a gross-up provision is tied to the calculation of operating cost passthroughs. In a typical commercial lease, each tenant will pay its proportionate share of the building's fixed operating costs, such as real estate taxes and insurance, and its variable costs, such as HVAC, utilities, and janitorial service. By passing through these costs to its tenants, a landlord is able to maximize the income stream for the property asset.
But without a gross-up provision, when vacancies rise, landlords shoulder the burden of operating expenses for the remaining tenants in an otherwise empty building.
To see how this works, take the following two examples without gross-up provisions. Suppose a landlord has recently completed construction on a five-story building. All five floors have been leased, with five tenants each occupying a floor in the building. Each lease requires payment of annual base rent and payment of one-fifth of the building's $300,000 operating costs, of which $200,000 are variable costs. In this ideal scenario, each tenant will pay the landlord base rent and $60,000 in operating expenses. Of this, $20,000 represents payment for the fi xed operating costs and $40,000 represents variable costs. Assuming a high enough base rent, this stable income stream largely covers the landlord's total ownership costs for the property.
But suppose the same landlord leases only two of the five floors during the first year of property ownership. Fixed operating expenses remain the same at $100,000. Because the building is occupied by only two tenants, the building's variable operating expenses, such as janitorial service and utilities, are $100,000 less. Each tenant will continue to pay its proportionate share of fixed ($20,000) and variable ($20,000) operating expenses, for a total of $80,000 combined for two tenants.
The lack of a gross-up mechanism impacts the landlord's income stream. In the first example, the landlord receives a total of $300,000 annually if all five tenants pay their proportionate share of the operating costs. In the second example, however, the landlord receives only $80,000 from the two tenants, leaving a shortfall of $120,000 that the landlord must pay. This is particularly frustrating to the landlord, since the majority of these variable costs were incurred by only two tenants.
A typical gross-up provision solves this problem:
“Operating Expenses for each calendar year shall be those actually incurred, provided however, that if the Building was not at least one hundred percent (100%) occupied during the entire calendar year including the Base Year, the variable portion of the Operating Expenses shall be adjusted to project the Operating Expenses as if the Building were one hundred percent (100%) occupied.”
In reliance on the gross-up provision, the landlord will estimate the variable portion of the operating expenses to 100 percent occupancy. In this case, since the variable operating expenses were $80,000 when the building had two tenants, the landlord will estimate variable operating expenses to be $200,000. When coupled with the fixed operating costs, the total operating costs are $300,000. The proportionate share of total operating expenses becomes $60,000. Without the gross-up provision, each tenant paid only $40,000. In other words, the gross-up provision returns the parties to the status quo as if the building were fully leased.
While a tenant may question the fairness of this gross-up, these variable operating expenses are attributable to the occupancy of the premises by the tenants. The HVAC system might otherwise be put into an energy saving mode when a floor is unoccupied. Likewise, janitorial service is unnecessary, while water and electricity would be a fraction of the cost for an unoccupied floor. For this reason, the two tenants incurred the actual variable operating costs. The gross-up provision benefits the tenant as well by creating budgetary certainty. If there is no gross-up provision, the annual operating expenses will vary greatly every year, depending on the occupancy of the building. But more important, a gross-up provision that includes a gross-up of variable expenses during the tenant's base year prevents a landlord from back-loading additional variable operating expenses in subsequent years when the property is fully leased. For this reason, the simple inclusion of a gross-up provision allows the landlord to preserve its income stream even when the building is less than 100 percent occupied. Do not negotiate it away.