• LEASING BASICS -- "Gross Up" Provisions
  • September 11, 2009 | Author: Victor A. Taylor
  • Law Firm: Parr Brown Gee & Loveless, A Professional Corporation - Salt Lake City Office
  • As a real estate professional, you have been asked to review a landlord’s “standard form” multi-tenant office lease on behalf of the tenant. As you are reading the provisions dealing with the pass-through of building operating expenses (referred to in leases variously as “Operating Expenses,” “Basic Costs,” “CAM Charges,” etc., but generally defined as those costs and expenses incurred by the landlord in the operation of the building), you come across something like the following provision (sometimes commonly referred to as a “gross up” provision):

    Notwithstanding the foregoing to the contrary, (a) the Operating Expenses that vary with occupancy and are attributable to any part of the term of this Lease in which less than one hundred percent (100%) of the rentable area of the Building is occupied by tenants will be adjusted by Landlord to the amount that the Operating Expenses would have been if one hundred percent (100%) of the rentable area of the Building had been occupied by tenants, and (b) if Landlord furnishes a service to tenants in the Building, the cost of which constitutes an Operating Expense, and a tenant other than Tenant has undertaken to perform such service itself, Operating Expenses shall be increased by the amount that Landlord would have incurred if Landlord had furnished such service to such tenant.

    You may not fully understand this provision, or you may say to yourself, “Wait a minute, that doesn’t seem fair. If the building is not fully leased, or if another tenant provides its own services, why should my operating expenses increase?” If so, your reaction would be similar to that of many other real estate professionals. As it turns out, however, this provision actually is fair and equitable to both the landlord and the tenant. Let me try and explain.

    Correctly drafted, a gross up provision relates only to Operating Expenses that “vary with occupancy”--so called “variable” expenses. Variable expenses are those expenses that will go up or down depending on the number of tenants in the Building, such as utilities, trash removal, management fees and janitorial services. That is, as to this type of expenses, the more tenants in the building, the higher the total expense, and vice versa. By contrast, so-called “fixed” expenses (which are not impacted by this provision) are those expenses that remain constant regardless of the number of tenants in the building, such as building liability insurance, landscaping maintenance, exterior window cleaning or a first-floor night watchman.

    An example should illustrate generally how subparagraph (a) of this provision is supposed to work. Let’s say that the building is 100% leased, has ten equal floors of 10,000 square feet each, and has ten tenants, each of which occupies one whole floor. And let’s say that the lease provides that the tenant is to pay its pro rata share of the Operating Expenses, which is calculated by multiplying the Operating Expenses by a fraction, the numerator of which is the square footage of the premises (10,000), and the denominator of which is the total square footage of the building (100,000), or 1/10. Finally, let’s assume that janitorial expenses are $1,000 per year per floor—so, $1,000 for one floor, $3,000 for three floors, $6,000 for six floors, etc. up to $10,000 for all ten floors. Therefore, in this example, the janitorial expenses for the entire building when fully leased would be $10,000, and the tenant would pay 1/10 of that amount or $1,000 (with the landlord collecting a total of $10,000 from all ten tenants). This is as it should be--the tenant receives $1,000 worth of janitorial services, and pays $1,000 for those services.

    Let’s change the example and say that there are only five tenants occupying five floors. Now, the total janitorial expenses would be only $5,000 ($1,000 per floor for five floors). Without the gross up provision, the tenant would pay its pro rata share of the Operating Expenses, or 1/10 of the total $5,000 cost of the janitorial services, or only $500, meaning that even though the tenant is still receiving $1,000 worth of janitorial services, it is paying only one-half of the cost of those services. The tenant receives a windfall and the landlord is short in its collections by half. Fortunately for the landlord (but fair to both the landlord and the tenant), subparagraph (a) of the above provision would “gross up” the $5,000 in janitorial expenses incurred with only a half-full building to the amount that the landlord would have incurred had the building been fully leased (that is, $10,000), and then the tenant’s pro rata share (1/10) is applied to that number instead of to $5,000. The result is that the tenant will pay 1/10 of $10,000, or $1,000, meaning the tenant will pay, and the landlord will collect, the full cost of providing janitorial services to the tenant’s floor.

    Subparagraph (b) of the above provision works in a similar way. Let’s take our first example above of a fully leased ten-story office building, and say that one of the other whole-floor tenants decides to provide its own janitorial services. This means that the landlord will provide janitorial services to only nine floors at a total cost of $9,000. Similar to the just prior example, without subparagraph (b) of the above provision, the tenant’s pro rata share of 1/10 applied to this $9,000 total cost would yield to the landlord only $900, or $100 short of the actual cost of providing janitorial services to the tenant. However, if subparagraph (b) is applied, then the $9,000 amount is grossed up to $10,000, the tenant’s pro rata share is applied to that number and the tenant will pay its fair share of $1,000. Therefore, although perhaps not apparent on an initial reading, both of these subparagraphs actually produce equitable results to both the landlord and the tenant.

    A few final observations:  (1) Many landlords of multi-tenant office buildings use 95% as the gross up percentage in their leases instead of 100% when the lease involves a base year, reflecting a typical 5% vacancy rate. Although this is generally fair to the tenant (and generally prevailing in the market), it can have a slightly inequitable result to the tenant if base year occupancy is at or below 95% (even if grossed up to 95%), and a subsequent year’s occupancy is above 95%. The resulting inequity is that the tenant will pay increased Operating Expenses merely as a result of building occupancy going above 95%, in addition to any increase resulting from higher Operating Expense unit costs. (2) On the other hand, using 95% (instead of 100%) in a lease in which there is no base year (that is, a lease in which the tenant pays its pro rata share of all operating expenses, and not just increases over a base year) makes little sense from the perspective of the landlord. As can be seen from the examples above, this would result in a gross up to only 95% of the correct total amount, leaving the landlord bearing the remaining 5%. (3) Finally, a tenant with a base year in which the building has significant vacancy will want to be sure that the gross up provision by its terms applies to base year expenses, and not just subsequent years. Otherwise, the tenant will pay increased operating expenses in subsequent years simply as a result of increased occupancy (as the total variable expenses go up with occupancy), in addition to normal unit cost increases.