United States: How To Handle Operating Expenses And Gross Up Clause (With Sample Clauses)

Operating Expense Provisions In Commercial Leases are far more complex than most parties to commercial leases suspect.

When analyzing such provisions the first and most obvious question is definitional: What constitutes an operating expense? The second and more complex question concerns how the operating expenses will be allocated among the landlord and the tenants. Since operating expenses can be both high and insidious, they require scrutiny and intense negotiation.

Defining Operating Expense. The term "operating expenses" is a term that requires careful definition through negotiated agreement. Skilled parties to leases will negotiate specific expenses that are to be included within the definition of the term and specific expenses that are to be excluded from the term.

Normally a capital expenditure is not an operating expense. However through the definition of what is included in "operating expenses," the landlord’s capital expenditures are oftentimes included. Most tenants will resist this and usually the compromise is to include only those capital expenditures that result in better efficiency (resulting in lower operating costs) and capital expenditures required by new laws or regulations. Tenants will want to define carefully what is a new law or regulation.

The way in which tenants are asked to reimburse the landlord for the operating expenses of the facility, be it a shopping center, office building, warehouse facility or otherwise, can also be a source of confusion. Sometimes the terms "gross rent" and "net rent" are used. When rent is stated as a "gross rent," the number includes the tenant’s share of operating expenses and "net rent" means that the number does not include any share of operating expenses.

Allocating The Operating Costs. There are a variety of ways that landlords pass operating expenses on to the tenants. A "full service" lease means that only operating expenses in excess of a stated dollar amount are passed through to the tenants.

Some leases require tenants to pay their share of operating expenses in excess of the operating expenses for the facility during a base year. When this is the case, the first year’s rent has been calculated to include the tenant’s share of such expenses for the first year and so the tenant is asked to pay its share of increases in operating expenses in subsequent years.

When leases require tenants to pay increases in operating expenses over a specified dollar amount, the amount is referred to as a "stop" or an "expense stop." Usually stops are expressed in terms of a dollar per square foot number and the tenant is then required to pay a share of all expenses in excess of this amount. Then too, in other leases, instead of requiring a tenant to pay actual increases or escalations in operating expenses over a base year, or in excess of a stop, sometimes the tenant is asked to pay increases based on a formula approach, i.e., increases in the Consumer Price Index or porter’s wages.

Other leases simply require the tenant to pay a share of the actual operating expenses and in this case the starting rent does not include any share of operating expenses. There are variations in how the tenant’s share is derived, but usually the tenant pays a proportionate share, i.e., in proportion to the area of the building that makes up the tenant’s premises, without regard to differences in location, floor or value. Thus, a tenant occupying 10,000 square feet of rentable area in a building with a total of 100,000 square feet of rentable area would pay 10 per cent of operating expenses. However, this simple principle is subject to variation and warrants careful attention by tenants.

One of the first questions is whether the tenant agrees that all operating expenses are passed through to the tenants and the landlord makes no contribution towards operating expenses. This issue arises whenever the building is not fully occupied. Does the landlord pay for a share of operating expenses that would otherwise be paid by tenants if not for the fact that there are vacancies? Landlords usually attempt to negotiate leases whereby the landlord is not required to contribute anything towards the operating expenses of the facility.

The simplest way for the landlord to pass through all operating expenses to each tenant is to simply define the tenant’s share of the operating expense as the ratio or the fraction that results from dividing the tenant’s rentable area by the rented (as contrasted to the rentable) area of the building or the shopping center or facility. However, many tenants will object to this and they will require that their share simply be their rentable square footage divided by the total rentable square footage of the facility.

Landlords also adjust operating expenses among the tenants when there are vacancies through a lease clause commonly called the "gross up" clause. The gross up clause provides the means whereby the landlord is able to pass on to tenants the share of operating expenses that would have been paid by whatever tenant would have occupied the vacant space. Only expenses that vary with occupancy are "grossed up."

These are called variable expenses and they include the cost of utilities, cleaning, repairs and maintenance. If the building has few tenants, these expenses will be less than if the building was fully occupied. Usually gross up clauses permit the landlord to gross up variable expenses to what the landlord reasonably calculates they would have been had the building been either 90 per cent or 95 per cent occupied. From the point of view of a tenant that is paying operating expenses on the basis of increases from a base year, there should be a "gross up" clause that grosses up the operating expenses of the base year in order to more closely approximate what the expenses would have been had the building been fully occupied in the base year.

But what if the tenant is paying actual expenses without regard to a base year? To a certain extent, the "gross up" clause is fair to both landlord and tenant. If the tenant with only 10 per cent of the building is the only tenant in the building and is the only one receiving the benefit of the variable expenses that increase because of the tenant, it is not fair for the tenant to pay only 10 per cent of such expenses. By grossing up these expenses, the tenant, while paying only 10 per cent, will be paying a fairer share of the actual amount of the variable expenses

Besides fluctuating with occupancy, a tenant’s share of operating expenses can vary depending on the leases that the landlord negotiates with other tenants in the building. Sometimes the landlord gives certain tenants special arrangements with respect to operating expenses. These can affect all other tenants’ share of operating expenses. These tenants usually fall into three categories, the anchor tenant, the exempt tenant, and the special circumstances tenant.

In many shopping centers, the landlord enters into leases with major or anchor tenants that have the leverage to insist that they will pay no share of operating expenses or a reduced share of operating expenses. Unless the landlord adjusts for this in the definition of the other tenants’ share of operating expenses, the landlord will end up paying the difference. In this case, you will see the non-anchor tenants’ share being defined as their rentable area divided by the total rentable area of the shopping center minus the rentable area of anchor tenants. The other shopping center tenants usually are willing to agree to this for they realize that without the anchor tenants, there can be no shopping center.

There are leases in which it seems that this method is concealed; the tenant needs to look out for this. These leases will provide that the tenant’s share is the tenant’s leaseable area divided by the landlord’s leaseable area. This looks innocent enough but then the lease (usually in another section) defines "Landlord’s leaseable area" as the rentable area of the shopping center or building minus the rentable area of anchor tenants. In all cases, scrutinize the definition of "anchor tenant."

Another problem is the exempt tenant. This is a tenant, who, for one reason or another, is really exempt from one of the categories of operating expenses. Sometimes this results in a reduction in the building’s total cost for that item of operating expense. For example, in some jurisdictions, a charitable institution or non-profit corporation or a government tenant occupying space can render that space exempt from real property taxes. In this situation, the lease with that tenant will usually exempt that tenant from paying any share of real property taxes.

As a result, the total real property taxes for the project or building will be reduced accordingly and all tenants will benefit from the reduction. However, if you add up the total of all of the percentage shares of the tenants who are required to reimburse the landlord for real property taxes, the total will not equal 100 per cent, because the exempt tenant pays no share. So even though the total real property bill is less, if the leases that the landlord has signed with the other tenants do not provide for a means whereby the landlord can gross up their share of real property taxes, the landlord has to pay the share that would have been paid by a non-exempt tenant occupying the space now occupied by the exempt tenant. The usual "gross up" clause is not designed to deal with this situation.

The third category is that of the special situation tenant. This is a tenant with whom the landlord enters into a special deal with respect to operating expenses. Supposing a bank wants to occupy the ground floor of an office building and to close the lease with this bank, the landlord agrees that the bank need not pay any share of elevator maintenance expenses, cleaning expenses or electricity expenses in the common areas of the upper building floors. The problem for the landlord is that the form lease signed by the other tenants failed to include a specially tailored gross up clause, to adjust the shares of these other tenants. The legal result is that the landlord is obligated to pay the share of the upper floor variable expenses that the landlord has agreed that the bank need not pay.

Another example is a ground lessor that occupies space in the building and negotiates a space lease where the ground lessor will not be charged any share of ground rent as a component of operating expenses. In the previous situation of the ground floor bank tenant, there is some benefit to the other tenants in actual reduced costs. However, in this situation with the ground lessor, if the total ground rent is not reduced, there is no benefit to the other tenants.

As a result of these special situations, even if a tenant is successful in negotiating to a point of full agreement and even if the lease is accurately drafted to express that agreement, the tenant still has to be diligent in making sure that it is billed operating expenses in accordance with the lease agreement.

Sometimes when faced with these situations, property managers will charge operating expenses in accordance with what the property managers consider is the custom in the industry. They will do so without carefully reading the leases that each tenant has negotiated and they end up sending out bills for operating expenses based on their assumption that every tenant’s lease is consistent with what they consider to be the custom in the industry or what they view as the "proper" way to allocate operating expenses.

According to these property managers, the custom and the "proper" way of allocating operating expenses is to allocate each particular item of expense only to those tenants who the property managers believe should be required to pay for that expense. There have even been situations where property managers have "grossed up" operating expenses even in the absence of a "gross up" clause in the leases. Consequently, a cottage industry has developed where there are now professional audit firms that specialize in auditing to discover these discrepancies.

As agents for their landlords, it seems that property managers believe that it is their fiduciary duty to their principal to charge operating expenses only to the tenants regardless of what the lease agreement says. They proceed on the basis that in no event is the landlord to pay any share of operating expenses, that by their very nature, operating expenses are to be charged to and paid only by tenants. When faced with exempt tenants or special situation tenants, the property managers without regard for whether the tenants have agreed that they may do so or not, will apply a variant of the "gross up" clause to allocate certain operating expenses in accordance with their own "standard" practices. If landlords in fact insist on this, then the draft of the lease should say so and the tenants would then have an opportunity to negotiate and agree or disagree.

Take the situation of a tenant such as an eleemosynary corporation that is exempt from paying real property taxes. Regardless of what the other tenant’s leases provide, sometimes the property managers will decide to effectively "gross up" their share of real property taxes. According to the reasoning of the property manager, if a tenant is not the tenant that has created the benefit of the real property tax exemption, then that tenant, regardless of the provisions of its lease, has to pay its share of real property taxes based on a percentage share derived from dividing that tenant’s rentable area by the total rentable area of only those tenants who similarly did not create the real property tax exemption. To these property managers, it may be irrelevant that the tenant’s lease only calls for that tenant to pay a fixed percentage share of operating expenses. The property manager will charge different percentage shares for different expense items in accordance with what the property manager views as customary in the community or views as appropriate.

After all, the property managers reason, the non-exempt tenants did not create the benefit of the exemption, they receive the benefit of the lowered taxes for the building and should not complain that they have to pay the share of the tenant that created the benefit. (Of course their presumption is that landlords are never to pay any share of operating expenses. In fact since the customary "gross up" clause only grosses up variable expenses, landlords do pay the share of fixed operating expenses that are not paid on account of vacancies.) In any event, the way that the property managers charge the tenants for operating expenses should be stated in the lease.

For the property managers to continue their practice, the leases of all other tenants should contain an appropriately tailored "gross up" clause. As described above, the usual gross up clause is not designed to deal with the situation of the government or non-profit tenant that creates a real property tax exemption or a ground lessor that is exempted from paying ground rent or a ground floor tenant that negotiates a lease whereby it pays no share of upper floor variable expenses. In these situations, the other tenants have not contractually bound themselves to pay a different share of operating expenses to permit the property managers’ method of charging these expenses.

In net leases, where tenants pay a share of actual operating expenses, property managers will bill separate groups of operating expenses on a dollar per square foot basis. The annual total for the expense category is divided by the total rentable area of the building to derive the rate per square foot cost of that expense category. Tenants usually pay their share of these operating expenses on an annual estimated basis with an annual reconciliation once the actual amounts are known. The estimate of the operating expenses for the year may take the form of a total budget for each category of expense as well as a rate per square foot for the category. For example:

The tenant is then billed $10.69 multiplied by the tenant’s rentable area. If the tenant’s lease requires the tenant to pay its proportionate share, i.e., the rentable area of its premises divided by the total rentable area of the building, then this method of charging operating expenses is consistent with the tenant’s lease agreement.

However, to address the exempt tenant or the tenant with a special circumstance, it may be that these dollar amounts per square foot may have been derived after the property manager has "grossed up" the expense in accordance with the property manager’s customary practices and notions of fairness as described above. Although the effect is the same, the "gross up" that occurs here is not a grossing up of the expenses but a modification of the formula for determining the tenant’s proportionate share of the expense category. If this is not disclosed in the billings provided to the tenant, the tenant will not be aware that the tenant will actually pay a share of certain expenses in a proportion different from that agreed to in the lease. So while it appears to the tenant that it is paying only the agreed upon percentage stated in its lease, the tenant is really paying a different percentage from that agreed to in the lease.

For example, if the property manager grossed up the ground rent category, the rate per square foot for this category would be derived by dividing the annual amount for ground rent by the total rentable area of the building minus the rentable area of the tenant who was not obligated to pay any share of ground rent. Similarly, if there was a tenant that was exempt from paying real property taxes, the rate per square foot for real property taxes would be derived by using as the denominator, the total rentable area of the building minus the rentable area of the exempt tenant.

This "grossing up" should be disclosed in the annual statement of estimated operating expenses. At times, the property manager will disclose the fact that it grossed up some of these expenses by placing an asterisk next to the item and then indicating the total square footage used for that category. Tenants who are not vigilant will miss this and will continue to think that they are paying for all expenses strictly in accordance with their agreed upon percentage or proportionate share as expressed in their lease.

If the property managers are to charge operating expenses in this manner, the landlords need to negotiate lease provisions that permit this practice. For example, if the special situation tenants are known in advance, the lease provision would read essentially as follows:

The blanks could then be filled in to reflect the bank that had the special arrangement to pay its own cleaning expenses or the ground lessor with the space lease that did not require the ground lessor to pay any share of ground rent. This would be similar to the shopping center leases where there are anchor tenants that are exempt from paying operating expenses. However, in these special category cases, instead of applying a different ratio or formula to all operating expenses as in the case of an anchor tenant in a shopping center, the practice here is to apply the different ratio or different formula only to specific categories of operating expenses.

However, in many cases, the special circumstance tenant is not known to the landlord in advance and a more generalized clause could read as follows:

This variant of the gross up clause reflects the actual practice of how certain property managers allocate and charge operating expenses to tenants of commercial property. Often this practice is used without any provision in the lease authorizing the practice and despite agreements to the contrary. Landlords should include some variant of the "gross up" clause to insure that the tenant and the landlord agree on the method used by the property managers in charging the tenants Operating Expenses. Lessees are cautioned to not only carefully negotiate their leases but after the lease has been signed to carefully monitor how they are being charged.