What is a “Gross-Up” provision in a commercial real estate lease?
Why does my lease have a gross-up provision? Does this mean I’m paying more than my share of operating expenses and the landlord is profiting accordingly?
The concept behind the gross-up is relatively simple but is often misunderstood by tenants and their brokers alike, and when properly structured is an acceptable methodology for the reimbursement of operating expenses within a commercial real estate lease.
What are Operating Expenses?
Operating Expenses are the costs incurred by the landlord to operate and maintain the property. A well written lease clearly defines which costs are, and are not, permissible for inclusion in the definition and calculation of Operating Expenses. Those expenses permitted by the lease for inclusion are passed through to the tenants in accordance with their pro rata square footage of the building.
There are two types of Operating Expenses, Fixed and Variable. Fixed Operating Expenses include costs that do not vary with building occupancy, such as taxes and insurance, for which the landlord is responsible regardless of the amount of vacancy in the building. Variable Operating Expenses are linked to the services required by the tenants, such as janitorial and utilities, the costs of which rise and fall with the occupancy of the building.
A gross-up provision enables the landlord to recover the actual, Variable Operating Expenses from the tenants on a pro rata basis as if the building was 95%-100% occupied.
Consider a 100,000 SF building that is 50% vacant and 50% leased to two tenants of equal size, or 25,000 SF each. For illustration, we will assume total Operating Expenses are $100,000 annually, 70% of which are Fixed and 30% of which are Variable.
As addressed above, tenant reimbursement of Fixed Operating Expenses is not subject to the gross-up, but is calculated based on the actual amount of such expenses incurred by the landlord and passed through to the tenants in accordance with their proportionate share of the square footage of the building:
Fixed Operating Expense (“FOE”) Reimbursement Calculation:
100,000 SF (Total Building) Proportionate Share Actual FOE Share of FOE
Tenant A (25,000 SF) 25% x $70,000 = $17,500
Tenant B (25,000 SF) 25% x $70,000 = $17,500
Vacancy (50,000 SF) 0% x $70,000 = $0
Tenant Reimbursement of FOE $35,000
Actual Total FOE $70,000
In this case, the landlord experiences a shortfall between the actual expenses incurred and the amount of reimbursement from the tenants. Provided the tenant leases have been negotiated correctly, the gross-up provision is not applicable to these expenses and the tenants have no obligation with regard to this shortfall.
Now let’s examine the Variable Operating Expense calculation, with and without a gross-up provision.
Variable Operating Expense (“VOE”) Reimbursement Calculation:
WITHOUT a gross-up provision, the actual amount of VOE would be applied to each tenant’s proportionate share, leaving the landlord with a shortfall for providing the tenant-required services:
100,000 SF (Total Building) Proportionate Share Actual VOE Share of VOE
Tenant A (25,000 SF) 25% x $30,000 = $7,500
Tenant B (25,000 SF) 25% x $30,000 = $7,500
Vacancy (50,000 SF) 0% x $30,000 = $0
Tenant Reimbursement of VOE $15,000
Actual Total VOE $30,000
WITH a 100% gross-up provision, the landlord is permitted to proportionately increase the actual VOE amount to reflect a fully occupied building. Mathematically, the 50% leased building in our example must increase its occupancy by 2X to achieve 100%, so the same 2X would be applied to actual VOE to arrive at a grossed-up VOE of $60k, thus enabling the landlord to fully recover the actual Variable Operating Expenses incurred:
100,000 SF (Total Building) Proportionate Share Grossed-Up VOE Share of VOE
Tenant A (25,000 SF) 25% x $60,000 = $15,000
Tenant B (25,000 SF) 25% x $60,000 = $15,000
Vacancy (50,000 SF) 0% x $60,000 = $0
Tenant Reimbursement of VOE $30,000
Actual Total VOE $30,000
Is this fair to the tenant?
Provided the gross-up provision applies only to Variable Operating Expenses, it is widely accepted as an appropriate way to ensure the tenants cover the costs related to their occupancy of the building. If the tenants were not in the building, the need for janitorial services, AC, water and electricity would be dramatically decreased. Without a gross-up provision, it would actually cost the landlord MORE to have tenants in the building than for the building to be vacant.The gross-up provision also enables tenants to budget with greater certainty due to the avoidance of substantial swings in operating expenses from one year to the next. Finally, in the case of gross lease where the tenant pays its proportionate share of operating expenses in excess of a “base year” amount, the gross-up prevents such base year from being artificially low if the building has significant vacancy during the tenant’s initial year of occupancy.
Fritsche Anderson has helped hundreds of tenants negotiate favorable operating expense and gross-up lease provisions since its inception in 2007. Contact us today for more insight on this important topic.