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Grossing Up Operating Expenses in Commercial Leases

July 12, 2011

Gross-ups are adjustments to building expenses that are made when such expenses are below normal levels due to building vacancies and other factors.

When buildings have vacancies, or one or more tenants perform certain standard building services themselves (e.g. nightly office cleaning), the mechanism in commercial leases designed to reimburse the landlord for operating expenses can malfunction. This may cause either undercharges or overcharges to the tenant, depending on the type of lease and the year in which the drop in expenses occurs. Gross-ups are intended to counteract this problem by adjusting expenses to the level they would be in a normal, fully operational building, with the landlord providing all standard building services to all tenants.

In most commercial leases, tenants are required to .....

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reimburse their landlords for their share of building expenses.  The reimbursement mechanism operates one of two ways, depending on the form of the lease:

  • “Net” leases, in which the tenant is charged a percentage (based on its share of the total building area) of total building costs each year
  • “Modified gross” leases, in which expenses are built into the rent (the rent is higher) and the tenant pays for its share of increases in expenses each year over the expenses for the base year.

For a full discussion of the differences between different lease types, see KBA’s LeaseTip™ entitled “Demystifying the Difference between Net and Gross Leases.”

When parts of a building are vacant or otherwise not receiving building standard services, the landlord’s operating costs for the building are less than normal.  This situation can be problematic when trying to calculate the proper share of building expenses for those tenants in occupancy and who are actually receiving all of the building services.

Grossing Up to Prevent Understated Tenant Reimbursements

If the reduction takes place anytime in a net lease, or in a year other than the base year of a modified gross lease, the tenant will pay less than its full share of expenses.  That’s because a reduction in overall expenses dilutes the tenant’s proper share of these costs.  Each tenant’s respective share remains fixed based on its percentage of the entire building, even though its actual share (based on only those tenants receiving services) may be higher.

Of course, calculating each tenant’s share as a percentage of occupied space, rather than total building space, could potentially fix this problem.  However, it is an imperfect solution because tenants in occupancy would have to pay disproportionate shares of fixed building expenses.  For example, a tenant who occupies 25% of a building, but due to vacancies is the only tenant in occupancy, would have to pay 100% of the expenses.  Thus, this single building tenant would have to pay 100% of landlord’s insurance costs for the property.

The better solution is to adjust the expenses to levels that would be present in a fully occupied building.  Here, in a building that is only 25% occupied, the property insurance costs would remain unchanged, but the abnormally low service costs, such as cleaning expenses, would be adjusted or “grossed up” to what they would be in a fully occupied building.  Now, the vacancy has no impact on the 25% tenant’s obligations.  Such tenant pays 25% of an undiluted amount – exactly what it would have paid had the building been full.

Every commercial lease should require that expenses be fully grossed up every year.

Grossing Up to Prevent Tenant Overbillings in Base Year Leases

Grossing up is especially important in base year leases to prevent windfalls to the landlord.  In modified gross leases with base years, the tenant is required to pay for all increases in expenses over the amounts incurred during the base year (typically the first year of the lease).  The idea is to provide a mechanism to protect the landlord against increases in costs due to inflation and other similar forces.  Each year, the building expenses are compared to what they were during the base year, and the tenant pays its share (based on its percentage of the entire building) of any resultant increases.  This mechanism keeps the landlord whole as costs rise.

If costs are suppressed during the base year due to building vacancies or other reasons, the base year will be abnormally low as compared to years where no such conditions exist.  If expenses thereafter increase to “normal” levels, when each year’s expenses are compared to the suppressed base amount, the increase for which a tenant is responsible becomes exaggerated.  This causes an annual overstatement of the tenant’s liability.

For example, if during a base year only 25% of a building needs to be cleaned, and the building fills up the following year, necessitating full cleaning, the cleaning expense will rise to four times its original level, even with no increase in cleaning rates by the vendor.  The tenant who occupies the original 25% will be required to pay 25% of this quadrupled increase.

Furthermore, because the base year expenses are used to calculate the tenant’s liability each year of the lease, this overstatement will occur every year of the lease term if the building remains fully occupied.  This creates an annual windfall for the landlord at the tenant’s expense.

To correct this, the base year expenses must be grossed up to normal full occupancy levels.  The low cleaning expense would be adjusted to what it would be in a full building, as should be done every year.  Then, if there is no increase in rates, the number will remain the same.  If rates increase, the number will rise accordingly.  Grossing up the base year expenses eliminates artificial increases and causes the expenses to rise only if normal market forces cause rates to increase.

Every base year lease should make a particular point to require that base year expenses be fully grossed up.

Fixed vs. Variable Expenses

Note that not all expenses vary in direct proportion to occupancy.  Many have a fixed component—a part that is unaffected by occupancy.  For example, while cleaning expenses may be highly variable, core building costs such as insurance or HVAC and elevator system repairs will not change significantly with variations in occupancy.  Each expense must be examined closely to determine if and to what extent a gross-up adjustment of the actual expense incurred is appropriate. 

The Building Owners and Managers Association (BOMA) has developed several suggested methods and calculations that some landlords are beginning to follow.  However, a landlord’s claim that it is following BOMA does not mean that its gross-up adjustments are correct.  BOMA has three different approaches to grossing up costs, and the one chosen by the landlord may not be appropriate.  Also, even though BOMA warns landlords to consider all of the relevant factors in performing gross-up calculations, many landlords simply follow BOMA’s generic formulas and forms without considering if they make sense in the circumstances.

Grossing Up for More than Occupancy

As mentioned above, occupancy is not the only factor that causes expense levels to be unusually low.  Warranty coverage of new building systems temporarily reduces maintenance costs and must be adjusted.  Also, in cases where management fees are calculated as a percentage of revenue, free and reduced rent periods will reduce management fees and must be adjusted to full rent levels.  Again, each expense must be carefully examined to ensure that these abnormalities are addressed to keep the pass-through/escalation clause operating as intended.

Conclusion

Grossing up is a necessary adjustment that should be required as part of the operating expense (as well as tax and utilities) reimbursement mechanism of every commercial lease.  It ensures that landlords receive full reimbursement of their expenses, and that tenants do not pay more than intended.

7 Comments »

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sgaawc said:

I really wanna thank you for this article, I think it’s one of the few articles (that explain the “grossing up” of operating expenses in a good way )in the web. the problem is that you didn’t attach some of the exercises,numerical examples and functions of the BOMA methods so that the article could be much interactive for the readers.

best regards

sgaawc said:

this is am example taken from “real estate accounting made easy” for Obioma Anthony Ebisike, 2010.

a copied text from the p56:
##///////////////////////////////////////////////////////////////
To help explain further how gross-up is calculated, let us use a simple
example. An office property is 87 percent occupied throughout the year.
Actual operating expenses subject to gross-up are $550,000, of which
$100,000 represents the fixed portion of the operating expenses; thus,
$450,000 is subject to gross-up. Assume per the lease that 95 percent is
defined as full occupancy of the property. Therefore, the total recoverable
expenses after gross-up would be determined as:

[Steps] [Description] [Amount]

1 Operating Expenses incurred and to be grossed-up
(includes fixed and variable components)
$550,000
2 Minus Fixed Component of Expense 100,000
3 Variable Component of Expense $450,000
4 Divide by Weighted Average Occupancy (WAO) during
the Year
87%
5 Variable Expense 517,241
6 Multiply by Full Occupancy as Defined by Lease (%) 95%
7 Grossed-up Variable Expense 491,379
8 Plus Fixed Component of Expense (from above) 100,000
9 Total Grossed-up Expense $591,379

To determine each tenant’s share of the recovery, the tenant’s pro rata
share would be multiplied by the total grossed-up cost of $591,379. Note
also that some tenants’ leases might specify that the landlord may not recover
more than 100 percent of the amount actually paid for operating
expenses; this stipulation has to be considered in determining the recoveries
from the tenants.
##//////////////////////////////////////////////////////////////

please note that it’s essential for you to separate the text of the example from 1-9 steps which are written as three columns.

the given(above) example is the only exercise mentioned in the gross up section in the book. “not really sure of the rest of the book, but dont think that there are further exercises in later chapters talk about gross up.”

good luck!

cwerely said:

Thank you for the comments. The example is assuming that the variable portion is 100% variable in relation to occupancy. This is rarely the case, except maybe for management fees and tenant electricity. This formula will work only if the variable potion is completely variable dependent on occupancy. If not, a variable factor (%) must be determined and applied against the variable portion before the grossed up amount is determined.

Steve said:

Thoughts on tenants who lease a large % of a building but are not currently occupying the space? If they are paying rent but not using the building services would you still gross up those expenses that are low due to the tenant not occupying? I have seen cases where a tenant is leasing 75+% of a building but not occupying/using the space and owners have chosen to not gross up because it is mainly impacting that tenant.

Lou Ferro said:

How you handle this depends on the type of lease the vacant tenant has and the tenant mix in the building. If it is a modified gross lease (where the base rent is meant to cover the first year’s operating expenses), the most accurate approach is to gross up the base year and lease year expenses. This year-to-year consistency keeps everyone on an even playing field. However, the vacant tenant that is not utilizing the building services should seek vacancy credits from the landlord for services like janitorial, premises electricity, HVAC, etc., as these services have been paid for through the rent, but are not being received, nor incurred by the landlord.

If the vacant tenant has a net lease (tenant’s share of expenses is paid in addition to the base rent), and other footage leased in the building is minimal, then billing actual (non-grossed-up) expenses is a short-cut way to make sure the vacant tenant is not paying for services not received. However, if the other tenants in the building are occupying their space and therefore using services, not grossing up will cause the occupying tenants to be underbilled (and the vacant tenant not getting the full value for the cost of services not used). Therefore, just like the modified gross lease above, the most accurate way to handle this and to assure that both the vacant tenants and occupying tenants are all treated fairly, is to gross up the annual expenses and then give vacancy credits to the vacant tenants. If the calculations are done correctly, you should end up with the occupying tenants paying their fair share of the services they received, the vacant tenants not paying for any services they did not receive and the landlord recouping from all the tenants in the aggregate, its actual annual costs incurred to provide the various services.

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