Most office leases allow landlords to recoup from tenants on a pro rata basis the operating expenses and taxes that the landlord pays to operate the building. When a building is not fully occupied and where a landlord is collecting from tenants their pro rata share of expenses, a standard clause in most office leases is commonly known as the “gross-up” provision. Essentially, it states that the landlord, from an accounting perspective, can increase the actual building operating expenses that it charges tenants to assume that the building is fully occupied. From negotiating office leases for over 25 years and being an attorney, I find that many of our clients and their counsel scratch their heads over this provision as it seems like the landlord is trying to pull a fast one. If structured properly, it is fair to both tenants and landlords. In this post, I explain the reason for this provision and how tenants can best protect themselves.
The rationale underlying grossing-up expenses is that it allows the landlord to collect actual expenses which vary based upon occupancy where the building is not fully occupied. Variable Expenses include janitorial service, utilities, and management fees. Fixed (or non-variable) Expenses include taxes, insurance, and security. Tenants need to be careful that the adjustment (or gross-up) applies only to variable expenses and that the landlord cannot collect more than the actual expense amount.
As illustrated below, where a landlord is allowed to gross-up variable expenses to assume full occupancy, it ensures that tenants pay their fair share of those expenses. Otherwise, when a building is not fully occupied, tenants would be paying less than their proportionate share of expenses.
- Building’s gross rentable area = 100,000 sf
- Building is 50% occupied by two tenants:
- 20% – 20,000 sf tenant
- 30% – 30,000 sf tenant
- Current Utility Service = $100,000
- Grossed-up Utility Service = $200,000
- If Utility expenses are NOT grossed-up to assume 100% occupancy, then the Landlord cannot collect all of the Utility expenses.
- 20% of $100,000 = $20,000 ($1/sf for the 20K sf tenant)
- 30% of $100,000 = $30,000 ($1/sf for the 30K sf tenant)
- The landlord would only collect $50,000 of the Utility expenses which total $100,000
- If Utility expenses are grossed-up to assume 100% occupancy, then the Landlord can collect ALL of the Utility expenses.
- 20% of $200,000 = $40,000 ($2/sf for the 20K sf tenant)
- 30% of $200,000 = $60,000 ($2/sf for the 30K sf tenant)
- The landlord collects all of the Utility expenses ($100,000).
A question that comes-up occasionally is: what is “full occupancy”? The conventional wisdom has been that a building is never 100% occupied, given the ebbs and flows of leasing, so 95% occupancy is deemed as “full occupancy”. Recently, however, I have seen some landlords push that to 100%. Depending upon a tenant’s size in the building, it may or may not be worth challenging the 100% assumption.
While this gross-up concept generally benefits landlords, it does benefit tenants where they have a full service (or gross) lease with a “base year” for tax and operating expenses where a building is not fully occupied. Under a “base year”, where taxes and operating expenses are included in the rent, the tenant pays for increases in taxes and operating expenses to the extent they exceed the base year amount.
To illustrate, if the Base Year is 2020 with a 50% occupied building and the Variable Operating Expenses are $5/sf in 2020 which is not grossed-up and they increase to $8/sf in 2021, then the tenant would be responsible for the incremental $3/sf cost; however, if Base Year 2020 is grossed-up to 95% occupancy which would result in $7/sf, then the tenant is only responsible for the incremental $1/sf. In that situation, it is to the tenant’s advantage to have the “base year” amount be as high as possible so grossing-up is to the tenant’s advantage.
It is also important to remember, as mentioned above, that the gross-up provision only applies to expenses which vary based upon occupancy. Also, tenants should make clear that the landlord cannot collect more than the actual expense that is being grossed-up. To ensure that the tenant is being properly charged, the tenant should negotiate into the lease an audit right which includes the ability to review the landlord’s calculations of the gross-up provision.
I hope this post brings some clarity to this often counter-intuitive lease provision. Feel free to contact me with questions.