Office buildings with vacancies often have distorted expense pass-throughs. This brief case study outlines why and how this can become an issue for tenants.
In 2009, ABC Company moves into a building that is only half occupied. ABC signs a 10-year base year lease, where it agrees to pay for increases in building expenses over time, with 2009 serving as its base year. The lease states that as building expenses rise from year to year, the landlord is to compare them to the expenses from 2009, and send ABC a bill for its share of the difference.
Over the next two years, the building starts to fill up as the landlord periodically leases out the remainder of the vacant space. By 2011, the building is 100% full. Everyone is happy, and everything feels right for each tenant, on every floor.
But something is wrong. For some reason in 2011, ABC receives a bill that is 10 times greater than expected!
How Did This Happen?
The landlord had simply done what the lease required: it deducted the 2009 Base Year expenses from the 2011 expenses and charged ABC for its share of the difference. But because the building was only half full in 2009, many of the building’s expenses were far below normal, causing the spread between 2009 and 2011 to be exaggerated. Even though expenses at similar buildings had risen by only 4% over those two years, the increase here was over 40%! ABC had not anticipated this, and had only budgeted for a normal increase in costs. This caught everyone by surprise and things started to feel much less right.
How to Fix This
ABC, either directly or through its lease audit professional, would have to work with the landlord to adjust the 2009 Base Year expenses to what they would have been at full occupancy (“grossed up”). By doing this, both 2011 and 2009 expenses would be based on a full building and the only difference in costs would be those caused by normal increases.
The argument goes as follows: ABC should not be forced to pay for large increases that were not part of the underlying business deal. After all, both ABC and the landlord had expected that ABC would be paying only for the normal inflationary changes to building costs. Instead, ABC was being charged to bring the building up to full occupancy. In this case, the base year should have been set at the true cost to operate the building at full capacity. And because base year expenses are used each year when calculating a tenant’s charges, this anomaly will result in overstated charges for every remaining year of its term! The moral of this story is that tenants should not be penalized for moving into a building that is not fully occupied when their actual use of space does not increase.
Preventative Solution: Better Lease Language
Leases should contain a so-called “gross up” clause, requiring adjustments to expenses to account for building vacancies. They should state that in any year in which there is building vacancy, the expenses must be adjusted (grossed up) to what they would be if the building had been full. This would have automatically required the normalization of 2009 expenses for ABC so that when the landlord calculated ABC’s increase, there would have been no fluctuations based on changes in occupancy.
Building vacancy causes problems in expense pass-throughs, and tenants would be wise to include properly worded gross-up clauses in their leases. In addition, even in the absence of a gross-up clause, tenants should seek the help of a qualified lease audit professional to identify expense anomalies and take steps needed to bring the lease back in line with the underlying business deal.