Lease “Gross-up” Provisions Made Easy

	LEASE “GROSS-UP” PROVISIONS MADE EASY by Robert D. McTaggart, Attorney At Law July 21, 2000 A commercial office building lease usually contains a “gross-up” provision. What is a “gross-up” provision, and why it is necessary? In most office building leases, a landlord is entitled to pass-through a share of the operating expenses for the building to each of the tenants. The allocation is usually based upon the portion of the total building space occupied by each tenant. If a tenant occupies only 10% of the total building space, then the tenant’s share of building operating expenses would typically be 10%, assuming that the lease does not contain a “gross-up” provision or provisions that limit the allocation (e.g. an “expense stop” or a cap). When a building is only partially occupied, a “gross-up” provision allows a landlord to pass through a larger amount of operating expenses than that which would be passed through if based upon the actual operating expenses for the building. At first glance, this may appear to be unfair. Why should a tenant that occupies only a portion of a building pay more than the tenant’s proportionate share of the actual operating expenses? Is it just because the landlord doesn’t want to bear the full burden of the cost of utilities and other expenses on the vacant space in the building? Actually, a well drafted “gross-up” provision is intended to allocate to the tenant only an estimated amount of operating expenses properly attributable to the tenant’s occupancy. To illustrate the need for a “gross-up” provision, let’s take an example. Assume that a tenant occupies only 10% of the rentable area of a building. Without a “gross-up” provision, the landlord would be allowed to allocate only 10% of the building’s actual operating expenses to that tenant. If the building were fully occupied, that allocation would be fair. Where a building is less than fully occupied, however, the utility usage of the occupied space would be greater than the unoccupied space. This is due to the additional lights and office equipment in the occupied space, as well as a narrower temperature range within which the occupied space must be maintained. Also, the occupied space requires janitorial service. Vacant parts of a building do not require the same levels of utilities usage and maintenance as the occupied portions. So, to pass-through only 10% of the actual total building operating expenses to the tenant would be to give the tenant the benefit of a portion of the savings attributable to the partial vacancy of the building. From the landlord’s point of view, the tenant should not be entitled to those savings. For purposes of illustration, let’s take the partially occupied building situation to the extreme. Imagine that our tenant (who occupies only 10% of the building) is the only tenant in the building. The building has one electrical meter that measures the electricity usage for the whole building. Assume that the landlord turns off the lights and HVAC system for the rest of the building. In our example, the electricity provided to the building would be used almost entirely for the benefit of that single tenant. If only 10% of the actual electrical usage for the building is passed on to the tenant, the landlord would be required to bear the other 90%, even though virtually all electrical usage was for the benefit of that tenant. Here is where a “gross-up” provision comes into play. With a “gross-up” provision, the landlord is entitled to “gross-up” the actual operating expenses for the building to an estimate of what those expenses would be if the building were fully occupied. In our extreme example, the landlord might estimate an amount for electrical usage that is approximately ten times that of the actual charges, so that when 10% of the “grossed-up” number is passed through to the tenant, the result is that the tenant pays the tenant’s fair share of the electricity expense. Even though our example is an extreme situation used for illustration purposes, a less than complete allocation of building operating expenses nevertheless occurs in every situation where a building is only partially occupied. A properly written “gross-up” provision allows a landlord to estimate what those expenses would be if the building were fully occupied, thereby resulting in a fair allocation of the expenses to the tenants. As for the concept of “fully occupied,” it is common for a “gross-up” provision to allow the landlord to “gross-up” variable expenses to an estimated amount that the expenses would be if the building were 95% occupied instead of 100%. Landlords are generally willing to concede that buildings are rarely 100% occupied. Even in the best of times, a building is likely to have some vacancy factor. Landlords typically assume that they will have to bear the utility expenses on some vacant space after a building is effectively fully occupied. With a vacancy factor of 5%, a “fully occupied” building would be 95% occupied. So, a “gross-up” provision is often written to allow the landlord to “gross-up” variable expenses as if the building were 95% occupied instead of 100% occupied. A note of caution to a tenant is in order. The manner in which a landlord might estimate expenses for a fully occupied building is subject to potential abuse. Also, certain expenses do not vary with occupancy levels. If property taxes and insurance premiums don’t vary with occupancy levels (a matter that may be subject to debate), then those expenses should not be “grossed-up.” Only those expenses that increase with increased occupancy should be “grossedup.” A tenant should assure that the “gross-up” provision is drafted fairly, and that the tenant has the right to audit the landlord’s operating expense statements. Although the landlord has a legitimate basis to require a “gross-up” provision in a lease, a tenant has a right to assure that it is properly written and will be applied fairly. Robert McTaggart is Board Certified as a specialist in the area of Commercial Real Estate Law by the Texas Board of Legal Specialization. He is a partner with the law firm of Palmer, Allen & McTaggart, L.L.P. and works with buyers, sellers, owners, tenants, investors and lenders to help complete real estate and business transactions. He also serves as legal counsel to the North Texas Commercial Association of Realtors®. The foregoing article is intended to give an overview of the topic discussed but is not intended as legal advice. If you have a specific legal question or need legal advice, contact an attorney of your choice.

LEASE “GROSS-UP” PROVISIONS MADE EASY
by Robert D. McTaggart, Attorney At Law

July 21, 2000

A commercial office building lease usually contains a “gross-up” provision. What is a
“gross-up” provision, and why it is necessary?

In most office building leases, a landlord is entitled to pass-through a share of the
operating expenses for the building to each of the tenants. The allocation is usually based upon
the portion of the total building space occupied by each tenant. If a tenant occupies only 10% of
the total building space, then the tenant’s share of building operating expenses would typically be
10%, assuming that the lease does not contain a “gross-up” provision or provisions that limit the
allocation (e.g. an “expense stop” or a cap).

When a building is only partially occupied, a “gross-up” provision allows a landlord to
pass through a larger amount of operating expenses than that which would be passed through if
based upon the actual operating expenses for the building. At first glance, this may appear to be
unfair. Why should a tenant that occupies only a portion of a building pay more than the tenant’s
proportionate share of the actual operating expenses? Is it just because the landlord doesn’t want
to bear the full burden of the cost of utilities and other expenses on the vacant space in the
building?

Actually, a well drafted “gross-up” provision is intended to allocate to the tenant only an
estimated amount of operating expenses properly attributable to the tenant’s occupancy. To
illustrate the need for a “gross-up” provision, let’s take an example. Assume that a tenant
occupies only 10% of the rentable area of a building. Without a “gross-up” provision, the
landlord would be allowed to allocate only 10% of the building’s actual operating expenses to
that tenant. If the building were fully occupied, that allocation would be fair. Where a building
is less than fully occupied, however, the utility usage of the occupied space would be greater
than the unoccupied space. This is due to the additional lights and office equipment in the
occupied space, as well as a narrower temperature range within which the occupied space must
be maintained. Also, the occupied space requires janitorial service. Vacant parts of a building
do not require the same levels of utilities usage and maintenance as the occupied portions.

So, to pass-through only 10% of the actual total building operating expenses to the tenant
would be to give the tenant the benefit of a portion of the savings attributable to the partial
vacancy of the building. From the landlord’s point of view, the tenant should not be entitled to
those savings.

For purposes of illustration, let’s take the partially occupied building situation to the
extreme. Imagine that our tenant (who occupies only 10% of the building) is the only tenant in
the building. The building has one electrical meter that measures the electricity usage for the
whole building. Assume that the landlord turns off the lights and HVAC system for the rest of
the building. In our example, the electricity provided to the building would be used almost
entirely for the benefit of that single tenant. If only 10% of the actual electrical usage for the
building is passed on to the tenant, the landlord would be required to bear the other 90%, even
though virtually all electrical usage was for the benefit of that tenant.

Here is where a “gross-up” provision comes into play. With a “gross-up” provision, the
landlord is entitled to “gross-up” the actual operating expenses for the building to an estimate of
what those expenses would be if the building were fully occupied. In our extreme example, the
landlord might estimate an amount for electrical usage that is approximately ten times that of the
actual charges, so that when 10% of the “grossed-up” number is passed through to the tenant, the
result is that the tenant pays the tenant’s fair share of the electricity expense.

Even though our example is an extreme situation used for illustration purposes, a less
than complete allocation of building operating expenses nevertheless occurs in every situation
where a building is only partially occupied. A properly written “gross-up” provision allows a
landlord to estimate what those expenses would be if the building were fully occupied, thereby
resulting in a fair allocation of the expenses to the tenants.

As for the concept of “fully occupied,” it is common for a “gross-up” provision to allow
the landlord to “gross-up” variable expenses to an estimated amount that the expenses would be
if the building were 95% occupied instead of 100%. Landlords are generally willing to concede
that buildings are rarely 100% occupied. Even in the best of times, a building is likely to have
some vacancy factor. Landlords typically assume that they will have to bear the utility expenses
on some vacant space after a building is effectively fully occupied. With a vacancy factor of 5%,
a “fully occupied” building would be 95% occupied. So, a “gross-up” provision is often written
to allow the landlord to “gross-up” variable expenses as if the building were 95% occupied
instead of 100% occupied.

A note of caution to a tenant is in order. The manner in which a landlord might estimate
expenses for a fully occupied building is subject to potential abuse. Also, certain expenses do
not vary with occupancy levels. If property taxes and insurance premiums don’t vary with
occupancy levels (a matter that may be subject to debate), then those expenses should not be
“grossed-up.” Only those expenses that increase with increased occupancy should be “grossedup.”
A tenant should assure that the “gross-up” provision is drafted fairly, and that the tenant
has the right to audit the landlord’s operating expense statements.

Although the landlord has a legitimate basis to require a “gross-up” provision in a lease, a
tenant has a right to assure that it is properly written and will be applied fairly.
Robert McTaggart is Board Certified as a specialist in the area of Commercial Real Estate
Law by the Texas Board of Legal Specialization. He is a partner with the law firm of
Palmer, Allen & McTaggart, L.L.P. and works with buyers, sellers, owners, tenants,
investors and lenders to help complete real estate and business transactions. He also serves
as legal counsel to the North Texas Commercial Association of Realtors®.

The foregoing article is intended to give an overview of the topic discussed but is not
intended as legal advice. If you have a specific legal question or need legal advice, contact an
attorney of your choice.

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LEASE “GROSS-UP” PROVISIONS MADE EASY by Robert D. McTaggart, Attorney At Law

LEASE “GROSS-UP” PROVISIONS MADE EASY
by Robert D. McTaggart, Attorney At Law