Tenants need to protect themselves from aberrations in their base year for operating expenses to avoid being hit with unexpected (and potentially large) escalation payments in later years. The way to do that is with a “gross-up” provision that is fair to both the tenant and the landlord.
In today’s issue, we focus on six issues to cover in your lease’s gross-up provision.
As we head into the Presidential campaign nutty (more nutty?) season, one of my favorite sportswriters, Jason Gay of the Wall Street Journal, recently suggested that, with two of the three scheduled debates clashing with NFL football, we should mix the two and hold the debates during the games.
Not just at the same time, but as part of the same event.
Mr. Gay suggests that we put the candidates on personalized football carts in opposite end zones and drive them to midfield for two minutes of action during all that football downtime, while having them square off big time as part of the halftime show.
To those who would scoff at the idea, Mr. Gay responds that it “confers exactly the right amount of respect upon this Presidential race” and the ratings would be “huge! … don’t act like you wouldn’t watch.”
We at Leasing Illustrated are willing to go one better on Mr. Gay of the lame stream media.
Why not combine NFL games with lease negotiations?
As Mr. Gay indicates, the WSJ sports department once calculated that there are on average only eleven minutes of action in a typical three hour NFL football game.
There’s more action than that at a lease negotiation, especially if you count coffee spills. On occasion, there are even harder hits (just try asking a landlord for something not included in the term sheet)!
Make it more exciting and put the conference room table at the 50 yard line and see how long we all last. And iksnay on the observation that the lawyers will survive since cockroaches can survive a nuclear winter.
Where am I going with this? Who knows?
But in a campaign season where candidates regularly exaggerate their indispensability to the nation and pump up their value with little or no connection to reality, the commercial leasing version of such expansion of the facts is actually quite benign.
I am talking about a lease’s “gross-up” provision.
The basic idea is quite equitable. If less than all or an agreed upon percentage (e.g. 95%) of the office space in a building is occupied, then in order to “normalize” operating expenses, the parties agree to include in operating expenses the amount by which operating expenses would haveincreased had such office space in the Building been occupied and operational and had all services been provided to all tenants.
This helps avoid large aberrations in the operating expenses in any particular year unless due to actual increases in costs.
If the operating expenses are unusually low in a tenant’s base year due to low building occupancy, then as the building fills up the tenant’s operating expense escalation will increase exponentially to cover both annual increases in the landlord’s costs (which a tenant expects each year) and also increases in landlord’s costs due to the addition of new tenants and the additional services needed for such new tenants.
By the same token, if in a later year the operating expenses are unusually low due to low building occupancy, it is unfair to the landlord whose costs will likely not decrease proportionately with the percentage of vacancies and who will have less tenants among which to spread those costs.
But as with any lease provision that starts off sounding equitable, there are potential pitfalls and traps for the unwary.
Without getting into further debate, leasing candidates would do well to tackle the following six issues in their operating expense gross-up provisions:
State the normalization. Your lease should clearly indicate that the operating expenses will be normalized by increasing such operating expenses by the amount by which those operating expenses that vary with occupancy would have increased “but for” the reduced occupancy, services or expenses.
Set occupancy assumption. Your lease will need to indicate whether the presumption on which the increase in operating expenses is based is 100% occupancy, 95% occupancy or some other amount. Generally, it is hard for any building to achieve 100% occupancy so 95% is a reasonable amount to assume.
Address services not provided. Your lease should increase operating expenses for work or services which would constitute operating expenses that are not furnished due to portions of the building not being occupied or leased, because such work or services are not required by the tenant of such portion of the building, or because such tenant is itself obtaining and providing such work or services.
Focus on new construction or renovation. Your lease should increase operating expenses with respect to new construction or other renovations, if (a) portions of the common elements of the building (e.g., the lobby) are not in service, (b) any building systems are not in operation or (c) your landlord will not incur the full cost of maintaining a portion of the building systems. Your landlord might not incur the full cost of maintaining a particular building system if it is covered by a service contract that is provided by the manufacturer without charge or for a reduced rate after installation, or because no service contract is required since such building system is new and under warranty or not yet in need of customary maintenance.
Cover base year. The “gross up” should apply in both the applicable comparison year(s) and the base year. The initial drafts of some leases only provide for the gross-up during comparison years which is patently unfair to you as tenant. You must include the base year or a provision meant to provide equitable normalization of operating expenses will work to your disadvantage.
Address in the term sheet. As with any important business point, the term sheet stage is when you have the most leverage and it will be helpful to raise the concept at that point and confirm that the gross up applies to the base year.
The telling question about the debates is whether you intend to DVR the early season NFL games or the Presidential debates deciding the future of the free world (or whether you are a crotchety old leasing lawyer who cannot even work the DVR). Follow the suggestions above and you will at least not miss out on operating expense escalation protection.
This newsletter has been fact checked by Lester Holt, Politico and Josiah Bartlet.