How “Grossing Up” Operating Expenses Affects your Lease Costs

Lease Tips™

How “Grossing Up” Operating Expenses Affects your Lease Costs

November 10, 2008

Gross-ups are adjustments to a building’s expenses to bring them up to what they would be were the building fully operational.

Many leases require landlords to gross up building operating expenses as part of the calculation of tenant pass-throughs. This article will explore why gross-ups are used and how they are calculated.

Why Are Gross-Ups Necessary?

Gross-ups enable operating expense pass-throughs to conform to their underlying purpose.

Building services are not individualized: Tenants are often required to reimburse the landlord for the tenant’s fair share of building expenses. However, services are not rendered to tenants individually; they are rendered to the building as a whole. Similarly, costs are not isolated for each individual tenant; they are aggregated for the building as a whole. They are then divided among the tenants according to their respective shares of the building.
Building vacancy dilutes the expense total: Building vacancy reduces expenses that vary with occupancy (such as cleaning, utilities, maintenance, and supplies). Because tenants’ costs are calculated based on their share of the entire building, tenants end up paying a share of a reduced expense level. As a result, the landlord may not receive the full expense reimbursement it is expecting.

Grossing Up a Base Year

Vacancy in a Base Year causes recurring tenant overcharges. Vacancy can create an inequity against the tenant when it occurs in a base year. In many leases, the tenant is obligated to pay for increases in costs over what they were in an agreed-upon base year. If the building has vacancy in that year, building expenses will be abnormally low, resulting in overstated increases in later years.

This is a serious problem for tenants because a low base year will result in overstated increases for every subsequent year of the lease.

Grossing up base year fixes the problem. It results in the tenant paying for the expected increases in expenses.

Fixed vs. Variable Expenses

Not all expenses vary in direct proportion to occupancy: Many have a fixed component—a part that is unaffected by occupancy.

Lobby and common areas must be cleaned regardless of occupancy levels
Tenant areas must be minimally heated and ventilated even when they are vacant

Each expense must be examined closely to determine the correct gross-up result.

Grossing Up for More than Occupancy

Similar adjustments necessary to achieve full operational cost levels: Occupancy is not the only factor that causes expense levels to be unusually low.

New building systems: warranty coverage temporarily reduces maintenance costs
Free rent periods: temporarily reduce management fees (where fees calculated as percentage of revenues)

If either of these occurs in an escalation year, the landlord will not be fully reimbursed for expenses. If either occurs in a base year, the tenant’s increases will be overstated for the life of the lease.

Clear Lease Language Avoids Disputes

Most landlords will recognize the inequities that result from the failure to adjust for artificially suppressed expenses, and will adjust expenses without the need for explicit lease language. However, spelling out the methodology and purpose of these adjustments in the lease goes a long way toward avoiding disputes and preserving landlord-tenant relationships.

How to Verify Proper Adjustments

As with all operating expenses, having clear lease language is only the first step in managing costs. It is imperative that all calculations, including the treatment and adjustments related to grossing up expenses, be verified by lease audit professionals to ensure that proper assumptions are made and that the intent of the lease is being followed.

If you would like advice in negotiating and/or interpreting lease language, or would like us to review your charges, please contact us.

One Comment »

Maria Cook said:

I found this site very helpful and will come back again to refresh on lease negoations and pass thru operating expenses which are confusing to say the least to an administrator.

Thank you

# 4 March 2010 at 9:49 am