Gross up provisions serve to mitigate the adverse impact of fluctuations in operating costs to the benefit of both landlords and tenants. It may seem counterintuitive that artificially inflating operating expenses is in the best interest of the tenant, but in this article I will show why tenants should ensure that gross up provisions are always included in their full service leases.
In full service leases, all the costs of occupancy are included in the quoted rental rate. Operating expenses (including janitorial, trash removal, utilities, etc.), real estate taxes, and insurance are all covered under base rent. Tenants are only responsible for increases in the costs of ownership above amount set in their first year of occupancy (base year). If tenants do not have gross up provisions in their leases they are at risk of significant increases in their rental obligation as buildings move from vacancy to full occupancy. The example below illustrates this point:
A tenant signs a new lease in a building that is 50% occupied without a gross up provision. The rent is $20/SF/yr which includes $6/SF/yr in costs of ownership with $2/SF/yr of that attributable to variable operating expenses. The tenant pays $20/SF/yr, the landlord nets $14/SF/yr, and the tenant’s base year expenses/costs of ownership are $6/SF/yr.
For the sake of simplicity, we will assume that there are no annual increases in the base rental rate. In year 2 the building is leased up to full occupancy. As a result of the increased number of tenants, variable operating expenses increase by $2/SF/yr to $4/SF/yr ($8/SF/yr total). Simply as a consequence of the building leasing up, a factor outside the tenant’s control, the cost of ownership has doubled. The tenant will be charged an additional $2/SF/yr as additional rent; resulting in a 10% increase in their rental obligation. That’s a big jump from a percentage standpoint and a potentially huge jump in actual rent depending on the tenant’s square footage.
Gross up provisions account for such increases in variable expenses, which are the result of increased occupancy. Landlords will still need to be competitive in terms of market rates, so tenants are still paying $20/SF/yr while eliminating the risk of absorbing the additional costs associated with leasing activity. In fact, tenants have an incentive for the expenses in their base year to be as high as possible because in most commercial leases landlords will not provide rental credits for any decreases in expenses in subsequent lease years.