Have you ever read the following language in the operating expense section of a lease and wondered why it was there?
“If, in the Base Year or any Expense Year, the Building is not 100% occupied, Expenses for such year shall be determined as if the Building had been 100% occupied throughout such year.”
Wonder no more. This is a “gross-up clause.” It is included in a lease to ensure the landlord is fully reimbursed by a tenant for the operating expenses the tenant actually used. If this is clear as mud to you, let me illustrate with an example.
Example A: The Fully Occupied Building
Tenant A leases 10,000 square feet in a 20,000 square foot building. Tenant A’s proportionate share of the total operating expenses is 50% because they occupy 50% of the building. If the other 10,000 square feet (or 50% of the building) is occupied by another tenant (Tenant B), operating expenses for the building are split 50/50 between the two tenants. If total building operating expenses are $100,000, with each tenant paying 50% (or $50,000), the Landlord is being fully reimbursed for all expenses by the two tenants.
Example B: The Partially Occupied Building (No Gross-up Clause)
What happens if Tenant B moves out of the building? The Landlord doesn’t have to clean the vacant space and may adjust the temperature setting on that half of the building to save money on electricity while it is unoccupied. Also, less electricity is being used because computers are not plugged in and lights do not need to be on all day. So, in this instance, the total building operating expenses go down to $75,000. Without a gross-up clause, Tenant A only has to pay 50% of the total (or $37,500).
As you can see, without a gross-up clause, Tenant A is getting a windfall because we already know from Example A that it costs $50,000 to run Tenant A’s portion of the building. The landlord is not only foregoing rent on the vacant half of the building, but also losing $12,500 in operating expense recovery from Tenant A.
Example C: The Partially Occupied Building (Gross-up Clause)
The tables can easily be turned with a gross-up clause. If the landlord grossed up all operating expenses, the landlord would calculate expenses by dividing $75,000 by 50% (the portion of the building occupied by Tenant A) to get to $150,000 for total building expenses. Since we have already seen that the operating expenses for a fully occupied building are only $100,000, we can see that the gross-up results in an artificially inflated total. Tenant A would be responsible for its proportionate share (50%) of this grossed up number (or $75,000) and the landlord would have a windfall because Tenant A would be paying all of the expenses for its own space and the vacant space.
Moral of the story?
Not having a gross-up clause can be detrimental to the landlord but grossing up all operating expenses is detrimental to the Tenant.
So, how do you protect your client in a multi-tenant building?
If you are representing a tenant in negotiating a new lease or are reviewing operating expense statements from a landlord on behalf of an existing tenant, make sure the lease allows for the gross up of variable expenses only. Variable expenses are those that fluctuate based on occupancy such as utilities and janitorial. Non-variable expenses include taxes and insurance.
If only variable expenses are allowed to be grossed up, the net result should be a grossed-up number closer to the $100,000 in expenses actually incurred when the building was fully occupied. After Tenant A pays its proportionate share of the grossed-up number, or $50,000, the landlord is responsible only for the balance of the actual expenses ($75,000 less Tenant A’s $50,000 reimbursement) or $25,000.00, a more equitable result.
Not all leases start and end at the same time. Landlord’s plan for building vacancies; tenants should too.