The COVID-19 pandemic has had a dramatic impact on commercial leasing for both tenants and landlords. Proactive landlords are wisely having lease modification discussions with their existing tenants and some are offering rental concessions to new tenants. As vacancies begin to rise, consider adding a gross-up provision to any lease modification or new lease. A gross-up provision can help to offset the financial burden of vacancies and can save tenants money over the long term, improving leasing outcomes for both sides.
What is a gross-up provision?
It is common in commercial leases for tenants to reimburse their landlords for a portion of the building’s operating expenses, in addition to paying the monthly base rent. Operating expenses include both fixed costs and variable costs. Tenants with base year or expense stop leases are generally responsible for paying for operating expenses in excess of their base year or expense stop amount. The tenant’s portion of the operating expenses is generally based on the tenant’s proportionate share of the area within the building. If a building isn’t fully occupied, the landlord ends up carrying the burden of the operating expenses allocated to the vacancies, unless the landlord includes a gross-up provision in all leases.
A gross-up provision permits a landlord to calculate and allocate operating costs as if the building was fully occupied, thereby allowing the landlord to “overstate” certain operating costs of the building. Only operating costs that vary by rates of occupancy within the building will qualify for the gross-up provision. These “variable costs” are those expenses that will increase or decrease depending on the number of tenants in the building and generally include utilities, trash removal, management fees and janitorial services. By contrast, fixed expenses, which do not vary by occupancy levels, should not be grossed up. Fixed expenses include real estate taxes, building liability insurance and landscaping maintenance.
The following examples demonstrate the mechanics of a gross-up provision:
Example 1—When a building is at full occupancy
Gross-up provision Included
Building occupancy 100 percent
Variable operating cost $10,000
20 percent tenant $2,000
80 percent other tenants $8,000
Landlord portion $0.00
In the above example, a gross-up provision is included in the lease, but a “gross-up” is not required since the building is at full occupancy. One hundred percent of the total operating costs are allocated to the tenants of the building. The “20 percent tenant” pays its 20 percent pro-rata share of operating expenses and the remaining 80 percent is paid by the various other tenants in the building. The landlord’s share of operating expenses is $0.
Example 2—Building with vacancies
Gross-up provision None Included
Building occupancy 60 percent 60 percent
Variable operating costs $6,000 $10,000
20 percent tenant A $1,200 $2,000
40 percent other tenants $2,400 $4,000
Landlord portion $2,400 $0.00
*Actual variable operating expenses of $6,000 have been grossed up to $10,000.
In this example, the building is at 60 percent occupancy. The actual variable operating costs are $6,000.
If a lease does not include a gross-up provision, the actual variable operating costs will be allocated proportionately to the remaining tenants of the building, leaving the landlord with the burden of paying $2,400 of operating expenses. This results from the fact that each tenant’s proportionate share is the ratio of the tenant’s space to the total space in the building rather than the ratio of operating expenses attributed to the tenant’s space to the total operating expenses for the building.
If a gross-up provision is included, the landlord is allowed to “overstate” the actual variable operating expenses of $6,000 to $10,000, the amount those costs would have been had the building been at full occupancy. That additional $4,000 will be allocated among the tenants based on their pro-rata share in the building. Thus, the $4,000 will be allocated as follows: $800 to the 20 percent tenant (increasing the 20 percent tenant’s total operating expenses obligation to $2,000) and $1,600 to the 40 percent tenants (increasing the 40 percent tenants’ total operating expenses obligation to $4,000). The landlord’s portion of the operating expenses with a gross-up provision will be $0.
Tenant benefits
A gross-up provision can be beneficial to tenants as well. For example, in many commercial leases, a tenant is responsible for paying its proportionate share of the building operating expenses over a certain base year amount. Typically, this is the first calendar year of the lease term. A base year lease establishes a baseline of operating expenses for the tenant. Thus, in the first year of a lease tenants will generally pay their base rent only, with no portion of the building’s operating expenses included in that rent (since the operating expenses of the building for that year are equal to the tenant’s base year operating expenses). The tenant will be responsible for the proportionate share of operating expenses that exceed those base year expenses incurred in the subsequent comparison years.
If a gross-us provision is not included in the tenant’s lease and the building is not at full occupancy, the tenant will ultimately have a low operating expense base year due to the lower occupancy of the building. In later years, as the building reaches full occupancy, the building’s operating expenses will increase as well. The tenants with the low base year (no gross-up provision) leases will end up paying a larger portion of those operating expenses based on their proportionate share. Thus, a gross-up provision helps increase the tenant’s base year/expense stop for operating expenses and protects the tenants from future spikes in operating expenses.
Conclusion
As the impact of COVID-19 continues to develop, lease provisions such as the above should be considered in lease modifications and new leases. Provisions like the gross-up enable landlords to offset the burden of vacant space and help protect the landlord’s income stream if and when vacancies arise. In certain circumstances, gross-up provisions also protect the tenant from overpaying for operating expenses.
Eduard Suleymanov, CPA, serves as director in the real estate group at accounting firm Marks Paneth LLP.