Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate, February 2009
Commercial leases often contain gross-up provisions relating to the calculation of the tenant's share of operating costs and realty taxes. In addition, commercial leases often include gross-up provisions relating to the calculation of the tenant's rentable area. What are gross-up provisions? Why are they necessary, and are they fair? What are the issues associated with gross-ups that landlords and tenants need to consider?
GROSS-UPS FOR OPERATING COSTS
As a property's occupancy rate rises or falls, certain operating costs also rise and fall. Costs which typically fluctuate with occupancy include janitorial, garbage removal and utility costs. Most commercial leases which allocate operating costs on a proportionate share basis include a provision that allows the landlord to increase or "gross-up" operating costs to reflect what the expenses would amount to if the property was fully occupied (or nearly so). That is, the landlord is empowered to overstate the expenses as if the property was fully tenanted. As a result, the amount the tenant must pay, based on its proportionate share, increases.
At first glance, this may appear to be unfair for tenants. However, generally speaking, the concept of grossing up expenses is reasonable as it ensures that tenants pay their fair share of operating costs. In other words, it results in the tenants who actually receive services, paying for them. An example best illustrates this point. Assume a tenant occupies 25% of a property and that the balance of the property is vacant. Also assume that because the balance of the property is vacant, all of the water consumption and janitorial work conducted at the property is due to the tenant's operations. Now if the lease is a net lease and the tenant is required to pay its proportionate share of operating costs, then the tenant would only be required to pay 25% of the water and janitorial bills notwithstanding that it was solely responsible for 100% of these expenditures. Gross-ups eliminate this inequity by effectively making the tenant responsible for payment of all of the water and janitorial costs.
It is worthwhile to note that while gross-up provisions for operating costs are commonly found in office leases, they are less common (but are by no means rare) in retail and industrial leases. This is due to the fact that there are few operating costs in retail and industrial properties that tend to fluctuate with vacancy. In a retail or industrial setting, it is common for tenants to arrange for their own janitorial service. Moreover, most of the operating expenses for retail and industrial properties relate to common areas that must be cleaned, repaired and maintained, regardless of occupancy levels.
Generally speaking, while gross-ups are fair and result in an equitable distribution of expenses, there are several issues that both landlords and tenants need to watch for and consider. These are:
1. Only Variable Costs Should be Subject to Gross-up. Only expenses that increase with increased occupancy should be grossed up. Accordingly, tenants should ensure that the lease only permits the grossing up of costs which fluctuate with occupancy. The grossing up of occupancy costs which do not fluctuate with occupancy would result in the tenant unfairly picking up a portion of the landlord's vacancy costs.
As an aside, landlords should ensure that their gross-up provisions permit the grossing up of management fees in circumstances where the fees are payable based on the gross revenue generated from the property (in other words, the fee fluctuates with occupancy). It is not uncommon to find leases that permit the grossing up of costs incurred by the landlord, but that do not provide for the grossing up of fees payable to the landlord. To avoid any ambiguity, the wording of gross-up clauses should be fine-tuned to ensure that management fees are covered.
2. Proper Occupancy Threshold. Even in the best of times, a property is likely to have some vacancy factor. Accordingly, tenants should seek to negotiate a vacancy factor into the occupancy threshold to be utilized by the landlord in grossing up expenses. For example, if it is reasonable to expect a 5% vacancy rate for the property at any given time, then the tenant should seek to amend the lease such that the landlord is permitted to gross up variable expenses as if the property were 95% occupied, as opposed to 100% occupied.
3. When Tenant Should Insist on Gross-up. Believe it or not, there are certain situations in which the tenant should insist on the landlord calculating operating costs on a grossed up basis. Ensuring that operating costs are grossed up is important for a tenant that pays for operating cost increases over and above a base year amount. Without a gross-up provision, if the property is not fully occupied during the base year, the base year amount will be lower due to the lower occupancy of the property. If the property became fully occupied in a later year, the tenant would be required to pay inflated increases. By insisting on a gross-up, a tenant under a semi-gross lease can eliminate the inequity created by vacancies occurring in the base year.
4. Potential For Abuse. The manner in which a landlord might estimate expenses for a fully occupied property is subject to potential abuse as there are many costs for which there is no clear distinction as to whether they fluctuate or do not fluctuate with occupancy. In addition, the methodology employed in estimating expenses for a fully occupied property is not based on hard and fast rules and, as such, is also an area where a landlord may take unfair liberties. Under such circumstances, the tenant should ensure that it retains the right to audit or scrutinize the landlord's gross-up calculations. Where possible, it would also be prudent for the tenant to expressly list those operating cost expenses which the landlord is permitted to gross up, with all other costs defaulting to non-gross-up status.
GROSS-UPS FOR REALTY TAXES
The rationale for gross-ups for realty taxes is the same as that outlined above for operating expenses. The issues described in subparagraphs 1 through 4 above equally apply to realty tax gross-ups.
It is important to note, however, that in some jurisdictions, realty taxes do not fluctuate based on vacancy levels (although a typical vacancy factor may be imputed to the property by the taxing authority). In these cases, a gross-up would be inappropriate. In addition, some jurisdictions (such as Ontario), issue tax bills based on full occupancy but permit property owners to later apply for a vacancy credit or rebate which may be applied towards the owners' tax payments. Where the credit or rebate system is employed, it would not be appropriate for the landlord to gross up the realty tax bill, however, it would be appropriate to deny the tenant the right to receive the benefit of any such credit or rebate.
RENTABLE AREA GROSS-UPS
Most office leases for space on multi-tenant floors gross-up the tenant's usable area (i.e., the area actually occupied by a tenant) to take into account that the landlord is not able to collect rent on the common area space on the floor (such as the corridors and washrooms). The gross-up takes the form of increasing the tenant's useable area by an amount equal to the tenant's proportionate share of the common area on the tenant's floor. The justification for the gross-up is that the landlord would have been able to collect rent on such areas if it had leased the whole floor to a single tenant. This form of gross-up conforms to The Building Owners & Managers Association (BOMA) 1980 standard of measurement for office premises.
More recently, landlords of office premises have also begun to gross up the usable areas in their buildings to take into account building common areas that provide services or amenities to all tenants, not just the tenants on multi-tenant floors (such as atrium space, foyers, and conference rooms). This additional gross-up is permitted under the BOMA 1996 measurement standard (but not the 1980 standard) and is justified by landlords on the basis that the areas provide a benefit to the tenant and the landlord would have been able to charge rent on the areas if it had leased them to third parties.
In retail leases, the rentable area of the premises is generally the same as the usable area (in other words, there is no gross-up). However, in the case of strip centres and power centres, some landlords have begun to gross up the area of the premises to include a proportionate share of certain common areas such as mechanical rooms and equipment rooms.
With respect to industrial leases, BOMA and The Society of Industrial and Office Realtors (SIOR) have developed a measurement standard known as the "Standard Methods For Measuring Floor Area in Industrial Buildings". The standard was adopted in 2004 and outlines two distinct methods of measuring industrial properties, being the Exterior Wall Methodology (Method A) and the Drip Line Methodology (Method B). For the most part, the BOMA/SIOR measurement standard functions similarly to the BOMA 1996 office standard. Accordingly, industrial tenants whose leases provide for measurement in accordance with the BOMA/SIOR standard can expect to have their usable areas grossed-up to include a proportionate share of common areas such as mechanical, sprinkler and equipment rooms.
As is the case with operating cost and realty tax gross-ups, there are several issues that both landlords and tenants need to watch for and consider in connection with rentable area gross-ups:
1. Office BOMA 1980 vs. BOMA 1996. Almost all landlords of office premises have adopted the BOMA 1996 standard of measurement. However, office tenants with significant negotiating leverage may be able to insist that the landlord utilize the BOMA 1980 standard of measurement for the purposes of calculating the tenant's rentable area. As noted above, the newer BOMA 1996 measurement standard permits the landlord to gross up the usable areas in their buildings to take into account main floor foyers and atriums and other building common areas that provide services or amenities to all tenants. The BOMA 1980 measurement standard only permits gross-ups in respect of the common areas on multi-tenant floors. The practical distinction between the BOMA 1996 and BOMA 1980 measurement standards is that tenants can expect to pay rent on a greater rentable area if the BOMA 1996 measurement standard is utilized.
2. Retail Gross-ups. As noted above, in the case of strip centres and power centres, some landlords have begun to gross up the area of the premises to include a proportionate share of certain common areas such as mechanical rooms and equipment rooms. Retail tenants with significant negotiating leverage may be able to deny the landlord the right to gross up the tenant's area.
3. Industrial – Exterior Wall Methodology (Method A) vs. the Drip Line Methodology (Method B). As noted above, the BOMA/SIOR industrial measurement standard outlines two distinct methods of measuring industrial properties, being the Exterior Wall Methodology (Method A) and the Drip Line Methodology (Method B). The Exterior Wall Methodology (Method A) measures to the outside of exterior walls to calculate areas. The Drip Line Methodology (Method B) measures to the most exterior drip line at the perimeter of the roof system to calculate areas. Method B is generally intended for wall-less industrial structures usually found in warmer climates. While Method A is the most conventional approach for measuring industrial buildings, Method B has gained popularity (even in colder climates), where landlords wish to maximize rentable area (information obtained from the website of Extreme Measures Inc. – http://www.xmeasures.com /). Of course, tenants of industrial properties with ample negotiating leverage should seek to deny the landlord the right to gross up their area or, at a minimum, insist that the landlord use the Exterior Wall Methodology (Method A) in lieu of the Drip Line Methodology (Method B).
4. Area Gross-up Caps. Regardless of the measurement standard utilized, some tenants may be able to negotiate a cap on the landlord's gross-up percentage factor. In other words, a tenant may be able to insist that no matter which measurement standard is utilized, the usable area of the premises may not be increased by more than a specific percentage factor (typically 7% to 15%). Caps on area gross-ups serve to limit the amount of non-usable space that the tenant is required to pay rent on. Where a building has a significant amount of common areas, a cap on gross-ups can prove useful.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.