Whether it’s a full service (gross) or triple net lease, the costs of occupancy are always “passed through” to the tenant. The costs of occupancy include operating expenses, real estate taxes, and insurance (in full service leases operating expenses include janitorial, trash removal, utilities, etc.). These expenses are divided amongst tenants based on their proportionate share, which is the ratio of their rentable square feet to the total rentable square footage of the building.
A tenant that occupies 2,500 SF in a 100,000 SF building therefore has a proportionate (pro rata) share of 2.5%. If the costs of occupancy are $200,000 per year, that tenant will be responsible for paying $5,000 of that amount either directly in a triple net lease or as part of their overall rent in a full service lease. As covered in my previous article, What are Pass-Throughs?, tenants with full service leases are only charged for increases in the costs of occupancy over their base year.
Example: If rent in the first year of a full service lease is $20/SF/yr with costs of ownership of $8/SF/yr, the tenant is paying $20/SF/yr with the landlord netting $12/SF/yr in profit. If those costs of ownership increase to $8.50/SF/yr in year 2, the tenant will be charged an additional $0.50/SF/yr as additional rent.
These expenses can increase or decrease from year to year due to various factors such as adding building amenities, increasing/decreasing building square footage, increasing efficiency of building systems or contracts, etc. The factor with the greatest impact on such expenses though is vacancy. In theory, a building that is 50% leased will have half the expenses as a fully leased building.
Gross up provisions are terms in commercial leases that call for the overstatement (or “grossing up”) of building operating expenses to a level that would be incurred if the building were fully leased. Only variable building expenses are subject to “gross up.” Building insurance is not affected by occupancy levels and while real estate taxes are not generally included, they can be impacted by a property’s occupancy (when assessed using the income approach). Interestingly, gross up provisions do not typically call for an overstatement based on 100% occupancy (90-95% is common).
Gross up provisions serve to mitigate the adverse impact of fluctuations in operating costs to the benefit of both landlords and tenants.