Why Gross-Up Provisions are a Smart Bet
Both commercial landlords and their tenants are always on the lookout for ways to save money and limit their financial exposure. If you haven’t done so yet, it may be time to consider using gross-up provisions in your commercial leases. These provisions ensure that tenants pay their share of operating expenses regardless of the property’s occupancy rate. Plus, they also protect tenants from unexpected cost increases, and provide landlords with an increased income to cover expenses when occupancy is low.
What are they?
In addition to rent, commercial landlords of multitenant properties typically require tenants to pay their share of the property’s operating expenses, including:
- Trash removal
Each tenant’s share is generally based on the percentage of the property’s total rentable square footage it occupies. When a property isn’t fully leased, the landlord ends up carrying the burden of the operating expenses allocated to the vacancies.
However, the operating expenses will usually be much higher for the occupied units than the unoccupied ones. For example, unoccupied units 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.
How do they benefit landlords?
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 is then based on the grossed-up expenses.
For example, a fully occupied property has $26,000 in variable expenses and $4,000 in fixed expenses, for a total of $30,000 in operating expenses. A tenant that occupies 10% of the property will pay operating expenses of $3,000 (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 $3,000? The total expenses will be $6,000 ($3,000 plus $3,000). Without a gross-up provision, the tenant’s share would be only $600 (10% of $6,000), despite the fact that it incurred all of the variable expenses, leaving the landlord to pay $5,400 in operating expenses.
With a gross-up of variable expenses to 100% (or $26,000), though, the total expenses would be $30,000 — as if it were fully occupied — and the tenant would pay $3,000 (all of its variable expenses). The landlord would still pay $3,000, but save $2,400, compared to the lease without the gross-up provision.
Are tenants protected?
Gross-up provisions also 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.
What are you waiting for?
Using gross-up provisions can benefit everyone involved. They help landlords manage costs regardless of vacancy rates, while allowing tenants to budget expenses without drastic increases out of their control. Whether you’re a landlord or a tenant, we can help you evaluate the pros and cons of incorporating a gross-up provision into your lease agreement.
For additional information contact Nick Sarinelli, CPA, CFE or Doug Collins, CPA on (973) 298-8500 or visit our real estate services page.