In this article, you’ll learn:

• The purpose and implications of the gross-up provision in office leases.
• How hidden costs can emerge from common area maintenance and operating expenses.
• The importance of selecting the right base year and negotiating expense caps.
• Strategies to ensure fair expense distribution and avoid financial pitfalls.

If you’re signing a lease in a multi-tenant office building, understanding the nuances of the gross-up provision is the linchpin to ensuring that your lease agreement doesn’t carry hidden financial surprises.

As tenants, it’s imperative to grasp the complexities of this provision to navigate the intricacies of shared expenses, particularly in the context of common area maintenance and operating costs. Delving into the world of the gross-up provision unveils a realm of financial fairness, stability, and predictability.

But in the mean time, there’s a lot to know about lease clauses before you can find your best office space for the best price. Enroll in the free course below to increase your knowledge as a tenant and optimize your office search like never before.

What is the Gross-Up Provision?

The gross-up provision in your commercial lease addresses the allocation of common area and operating expenses among tenants within a shared building or complex.

Common area expenses encompass the costs associated with maintaining and operating the shared spaces and amenities that benefit all tenants, such as lobbies, hallways, elevators, parking lots, landscaping, and security services.

The purpose of a gross-up provision is to ensure that the total expenses for operating and maintaining these common areas are distributed fairly among all tenants based on their occupancy. This provision accounts for situations where the building may not be fully occupied, which could lead to higher expenses per occupied space.

And the landlord is looking to offset their cost because in situations of high vacancy, the burden of covering the unfilled gap in fixed expenses often falls on the landlord’s shoulders. Since they count on the tenants to collectively contribute to covering these fixed costs, if there’s a lack of occupancy, the shortfall can be significant – a gap that the landlord must bridge.

Where Hidden Costs May Emerge for Tenants

While intended to ensure fair distribution of shared expenses, gross-up provisions can sometimes introduce an element of unpredictability. Because it operates on the principle of proportionality, it allocates costs based on occupancy or a tenant’s pro-rata share of square footage.

The pro-rata share represents the portion or percentage of total expenses that a tenant is responsible for, based on the size of their leased space relative to the entire building. This calculation ensures that each tenant contributes proportionately to the common area expenses, promoting fairness in cost distribution. But how can a tenant know what the total OpEx would cost if the building isn’t fully occupied? The landlord should calculate what the total costs among tenants would be according to a grossed-up, fully occupied state. 

Your landlord will also cover a portion of the operating expenses in the form of the expense stop. All costs beyond this stop are passed through to the tenants. The inclusion of expense caps provides tenants with a safety net against excessive cost increases. Negotiating for reasonable caps on operating expenses shields tenants from unexpected financial burdens that may arise from unforeseen circumstances or uncontrolled inflation. 

Setting the Right Base Year is Critical

Navigating the financial intricacies of the gross-up provision in commercial leases demands a strategic approach. The provision’s impact hinges on key elements: the choice of the base year, and expense caps.

Generally, the landlord will use a base year of OpEx to determine the amount they cover. Keep in mind that the base year isn’t fixed; it’s a dynamic element that influences how costs evolve over time.

The selection of the base year is a pivotal decision. Tenants should thoroughly evaluate historical data to choose a base year that best represents typical expenses. A well-chosen base year ensures that future adjustments are based on accurate benchmarks, mitigating the risk of unexpected spikes in expenses.

Because as the years progress and expenses fluctuate due to factors like inflation or building enhancements, the base year remains the anchor against which adjustments are measured.

However, this may not be an accurate assessment of all the expenses to be incurred in years to come and the tenant can really get taken advantage of if they don’t conduct due diligence. This is especially true for tenants of new buildings. If your landlord uses a base year approach to determine the building’s total OpEx cost when the property is not yet fully occupied, they will skew the estimate of future OpEx costs.

So, imagine a scenario where you sign a lease agreement with a fixed base year as the reference point for future expense calculations in a building with low occupancy. While this seems equitable, the catch lies in how these costs evolve over the course of your lease (and whether your broker had your best interest in mind).

Here’s a scenario: You sign an office lease in October, with plans to move in several months later in the new year. Inflation has been running high, so common area expenses are climbing year-over-year according to rising vendor costs. 

If you had negotiated the base year according to the year you signed rather than the rent commencement, you will be subject to additional costs you didn’t foresee. Because your landlord’s expense stop estimate is according to the prior year when inflation and subsequent operating expenses were lower. If you don’t work with a True Tenant Rep™, you are vulnerable to inflation swings that will come down to your responsibility to cover. 

Let’s say that operating expenses in your 50,000 square foot office totaled to $10 per square foot the year you found and negotiated your lease. This is the amount your landlord agreed to cover in their expense stop. Now, when you take occupancy the following year, you may be remiss to find a pretty substantial bill from your landlord. Because, inflation is running at 3.2%, raising the base-level cost of OpEx to $10.32 per square foot. Before you know it, that extra 30 cents will be multiplied by the 50,000 square feet in your lease to cost you an additional $16,000 in OpEx!

Tenants can also find themselves taken advantage of when they don’t negotiate cap into their leases. Because while landlords can’t directly control the service costs of vendors in a full-service lease, they do control what they charge you for the property management fee among the operating expense charges. As a result, you have the potential to ask for a percentage cap to avoid excessive fees.

If you are not careful, your operating expenses (which eventually can become the most expensive cost in your lease), can rise exponentially. Read more about how to ensure your OpEx benefits your budget.

Properly Grossing-Up

A properly negotiated gross-up clause is critical to the protection of your budget and should introduce predictability. Typically, the gross-up provision is triggered when the average occupancy for the year falls below a predetermined percentage, usually below 95% to 100%.

By negotiating a gross-up clause that activates at 95% occupancy, landlords ensure that expenses are recalibrated to reflect a scenario where the property is nearly fully occupied. This minimizes discrepancies in OpEx costs and prevents the remaining tenants from shouldering an unfair financial burden due to vacant units. When expenses are grossed up to 95%, it bridges the gap between actual occupancy and the potential expenses in a fully occupied state.

The importance of being well-versed in gross-up clauses is paramount against a backdrop of widespread vacancies and dismal office occupancy rates across the country. Now, more than ever, it may be likely that your building is not at maximum capacity.

Negotiate with a True Tenant Rep™

In essence, tenants should approach the negotiation of the gross-up provision with careful consideration and a strategic mindset. By ensuring that the provision activates when occupancy falls below a certain level, usually around 95% or higher, tenants safeguard against disproportionate financial burdens due to vacant spaces. This mechanism prevents tenants from subsidizing unoccupied areas, maintaining equity in expense distribution.

As you can see, there are many considerations with OpEx and the gross up provision. Failure to properly outline all these factors in the lease is leaving you open to getting taken advantage of. Luckily, you’re never alone when it comes to navigating commercial leases.

At iOptimize Realty, we are True Tenant Reps™ with over three decades of experience negotiating leases in the best interests of our corporate clients. We believe in directing commercial tenants to the properties and features that fit their needs best so we inserted all of our knowledge in the free course below. Enroll to learn how to find the best office for the best price and terms.