If you're negotiating a commercial lease, it's important to consider adding a gross-up provision. This provision can help you save money on variable costs in the event of an unexpected vacancy. To that end, we've provided you with a primer on the subject below. Keep reading to learn what a gross-up provision is, how it works, and how you can negotiate one into your next lease.
What is a gross-up provision in commercial real estate?
A gross-up provision is a common clause that's used in commercial real estate leases. At their core, gross-up provisions protect the landlord from having to pay additional amounts of the building operating expenses in the event of a high level of vacancy. They do so by allowing the landlord to charge each tenant a pro rata share of the variable operating expense that would have been incurred if the building was fully occupied.
A practical example of a gross-up clause
For the purposes of this example, let's say that a retail space with 10,000 feet of square footage can hold a maximum of five tenants. Let's also assume that the landlord's operating expenses for the building come out to approximately $50,000 each calendar year.
As such, each tenant pays $10,000 per year toward the operating expenses in addition to base rent. Of that $10,000, $7,500 goes to fixed expenses and $2,500 goes to variable costs, such as a janitorial service.
When the building is at full occupancy, the landlord collects a total of $50,000 per year to cover the building's operating expenses. Of that $50,000 total, $37,500 goes toward fixed expenses and $12,600 goes toward covering variable costs.
Now that we have that information, let's assume that only three of the five available retail spaces are being rented for the entire lease term.
No gross-up provision: At 3/5 occupancy, the landlord would only receive a total of 30,000 and only $7,500 (3 x $2,500) of that amount would go toward covering variable costs. In this scenario, the landlord becomes responsible for making up that $5,000 ($12,600 - $7,500) deficit in variable costs.
With a gross-up provision: The landlord is able to charge each tenant a proportionate share of the building's total variable cost. In this case, each tenant's pro rata share of the variable costs would be equal to $4,167 ($12,500/3), which would allow the building's variable costs to be fully covered.
Why is a gross-up provision an important part of a commercial lease?
Put simply, it's important to put a gross-up provision in a commercial lease because otherwise you might get stuck paying additional amounts of variable costs in the event of an unexpected vacancy. The provision allows you to pass on this cost to your tenants in the form of a larger-than-normal payment for variable expenses.
However, it's important to note that including this provision in a lease won't relieve you of your financial burden entirely. Even with the gross-up provision, you are still responsible for covering the missing portion of fixed expenses.
What should landlords look out for when putting a gross-up clause in a lease?
Typically, when putting a gross-up clause in a lease, there are three points of negotiation the landlord will need to consider. They are as follows:
- The occupancy rate at which the gross-up provision will be enforced: While there is no hard and fast rule about this, it will typically occur once the occupancy rate falls below 80%.
- The rate up to which the gross-up provision can apply: Most landlords will try to negotiate a gross-up clause that extends to 100% occupancy. However, in practice, it usually falls somewhere between 95% and 100%.
- An expense stop: Most tenants will try to negotiate an expense stop into the lease, which is the maximum amount they can spend on operating expenses. You'll want to make sure this number is higher than any gross-up payment they may need to make.
The bottom line
Including a gross-up provision in a lease can have a huge impact on a landlord's safety net. With that in mind, while these provisions are most common in triple net leases, you should try to negotiate them into any commercial lease. Use this post as your guide for getting started. Armed with this knowledge, you should have a much better idea of what a group of provision is, how it works, and how you can negotiate one of your own.