A critical component of commercial lease agreements is operating expenses, which are costs incurred by landlords to operate, manage, and maintain the property. Understanding how operating expenses are calculated and allocated is essential for both parties to ensure a fair and transparent leasing arrangement. In this article, we will discuss operating expenses in commercial lease agreements and explain the function of the often-misunderstood “gross-up” clause.
What are Operating Expenses?
In triple net lease agreements, tenants are typically required to pay their proportionate share of operating expenses in addition to the base rent. Operating expenses typically include:
- Property Taxes
- Insurance Premiums
- Utility Costs
- Common Area Maintenance Expenses
- Maintenance and Repair Costs
- Janitorial Services
- Pest Control
- Water or Sewer expenses
Operating expenses should exclude items that are not associated with the operation of the building. Some examples include:
- Costs associated with the operation of the business entity which constitutes the landlord. This includes general corporate overhead, general administrative expenses, and costs associated with the purchase, sale, or financing of the building.
- Depreciation charges.
- Costs solely related to leasing space to another tenant (brokers’ commissions, accounting fees, legal fees, and tenant improvements).
A tenant’s proportionate share is the portion of a building occupied by the tenant expressed as a percentage. In general, this percentage is determined by taking the tenant’s rentable square footage and dividing it by the building’s total rentable square footage.
Operating expense provisions in commercial lease agreements can be very complex, and certain provisions may appear to improperly favor the landlord, such as “gross-up” clauses. A gross-up clause is a provision in commercial lease agreements that adjusts certain variable operating expenses based on a predetermined building occupancy level.
At first glance, gross-up clauses may appear inequitable because they involve adjusting operating expenses based on a predetermined occupancy level, which could lead to the perception that tenants are being charged for space they do not occupy. However, this perception is incorrect, as the primary purpose of a gross-up clause is to promote fairness and ensure an equitable allocation of costs among tenants. Here are a couple of considerations to ensure gross-up clauses are not inequitable:
- The gross-up clause should only apply to those operating expenses which fluctuate based on the building’s occupancy level. These expenses often include items such as utilities, janitorial services, and security costs. The clause will establish a base occupancy level, typically expressed as a percentage (e.g., 95% or 100%). This is the level at which the building is considered fully occupied for the purpose of allocating the variable operating expenses.
- In negotiating gross-up provisions, the tenant should make sure that it is not responsible for any amount which is grossed up in excess of those amounts that the landlord actually pays. To enforce this concept, the landlord will typically provide tenants with an itemized statement of the adjusted operating expenses, including a clear explanation of the gross-up calculations. This promotes transparency and allows tenants to verify that the adjustments have been made accurately and fairly.
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This material is provided for informational purposes only. It is not intended to constitute legal advice, nor does it create a client-lawyer relationship between MNK Law and any recipient. Recipients should consult with counsel before taking any actions based on the information contained within this material