In commercial leasing, certain provisions generally are to the benefit of either the tenant or the landlord (rarely both). Gross up provisions are one of the few exceptions as they serve the interests of both parties. In my article, How “Gross Up” Provisions Benefit Tenants, I explained how they prevent large increases in passthroughs caused by rises in occupancy levels and the associated growth in operating expenses. Tenants have an incentive for their base year expenses to be as high as possible to lower the likelihood of any increases in subsequent lease years, but how does it benefit a landlord to artificially inflate their expenses?
There are many risks associated with commercial real estate investing/ownership (outlined in my article Risky Business: Factors to Consider When Investing in Commercial Real Estate), but perhaps the most dangerous is the unknown. Investors cannot create accurate projections with incomplete information, and if owners/landlords do not account for all the costs of ownership the assumptions under which they purchase assets will be wrong; leading to overpaying, lower than expected returns, etc.
Rental rates are driven by the market. The difference between the market rate and the costs of ownership is the landlord’s profit. The higher the expenses the lower the profit margin. If landlords want to maximize their profit while remaining competitive in the market (all things being equal), they are incentivized to keep their expenses as low as possible. If that’s the case, it again begs the question of why it benefits landlords to overstate/gross up their expenses.
One reason is the principle of erring on the side of safety. When analyzing whether or not to purchase an asset and at what price, investors must calculate the property’s potential net operating income (how much money they will make after expenses based on market rents and projected occupancy levels). The expenses, associated with tenancy, increase much quicker than market rents. If the market rate is $30/SF/yr and at 50% occupancy the costs of occupancy are $10/SF/yr ($4/SF/yr in variable operating expenses) but are $14/SF/yr at 100% occupancy ($8/SF/yr in variable operating expenses; indicating an additional $4/SF.yr), an investor would base their acquisition decisions on a net profit of $12/SF/yr NOT $16/SF/yr. The net operating income a property can generate over the holding period is the foundation of an investment decision.
Another reason is that landlords do not want to develop a bad reputation within the market. Landlords charge tenants for increases in operating expenses over the amount set in their base year. If landlords to not make allowances for increases in expenses that are a direct result of increased occupancy, they will be “overcharging” their existing tenants by making them absorb the costs brought about by the occupancy of new tenants. Ignorance is no excuse here and landlords that force their tenants to deal with the ramifications of their own negligence will not have tenants for long.
Finally, gross up provisions help landlords from a straight economic standpoint. To best illustrate this point, I present the following example:
Tenant A occupies 10,000 SF in a 100,000 SF building. Their proportionate share is 10%. The building at full occupancy has $500,000 in expenses that are passed through to the tenants. Therefore, Tenant A is responsible for $50,000 in expenses. The remaining tenants in the building are responsible for the remaining $450,000 (90% x $500,000 = $450,000). The landlord is responsible for $0 in expenses because the building is fully occupied.
If Tenant A still occupies 10,000 SF in the building, but the building is now only 50% occupied and expenses are thus only $250,000, the math changes substantially. Tenant A still only has a 10% proportionate share of the expenses. Based on the new expenses they pay only $25,000. The remaining tenants comprise 40% of the building and thus pay only $100,000 (40% x $250,000 = $100,000). This leaves the landlord with a bill of $125,000 (50% x $250,000 = $125,000). Had the landlord grossed up their expenses to account for the vacancy they could have included those costs in the asking rent charged to the tenants in their base year; owing little to nothing because they would have made allowances for increases attributed to leasing activity.
Gross up provisions help landlords stabilize projections of net operating income by already adding in the cost of increased expenses. When costs are already considered the additional revenue from increased occupancy directly adds to the bottom line.