All of the office leases that I have been involved with through the years include a gross up clause (usually 95%). The gross up clause applies to the operating expense reimbursements tenants pay as a part of their triple net or base year lease. The distinction in the type of lease is important. Certain leases, single net, double net and full service (also known as a gross lease) do not contain an operating expense reimbursement clause. 42floors has a good overview of the different types of commercial leases.
The operating expense reimbursement is a payment that occurs in addition to the base rent the tenant pays. At the beginning of each year, an operating expense estimate is provided to each tenant with their annual rent letter detailing the monthly payment based on the current years budget. Each tenant pays an amount based on the percentage of the building they occupy. An example might help explain this better:
The sample rent letter above outlines the annual payments for the tenant on a monthly basis. In this example, the tenant’s lease is a base year lease, meaning the tenant pays for the increase in costs above the base year as established in the lease (which is typically the year the tenant moves into the building unless they negotiated a new base year during a renewal). This $250,000 increase is multiplied by the tenants proportionate share of the building, 2.00% (3,000 RSF / 150,000 RSF = 2%). Divide that number by 12 and you have the monthly operating expense payment the tenant pays.
Where the Gross Up Comes In…
The gross up clause (let’s use 95%) affects the $250,000 escalation number. In instances where the Weighted Average Occupancy of a building is less than 95% (in some leases this number is 100%), then variable operating expenses (those expenses change as a result of more people being in the building) are grossed up as if the building were 95% occupied. Variable operating expenses would include expenses such as utilities (electricity, water, gas), cleaning costs and supplies, and trash removal. Expenses that do not change as a result of occupancy are taxes, insurance, landscaping and some repair accounts.
The variability of operating expenses can be challenging to figure out. In a suburban campus setting, using the operating expenses from a vacant building is the ideal scenario. In a high-rise office tower, it gets more complicated. One approach to determining the variability is by measuring the operating expenses of a vacant floor. With some adjustments, the cost to operate the building when vacant can be reasonably determined. The same method can be done in reverse for a full building and once you have the respective expenses you can determine the variability.
Putting the expense variability aside for the time being, a high level example may help explain the impact of grossing up the costs a bit better:
|100%||$10.00||10% = $1.00||90% = $9.00||$0.00|
|50% (no gross up clause)||$5.00||10% = $0.50||40% = $2.00||$2.50|
|50% (with 95% gross up)||$5.00||10% = $0.95||40% = $8.55||$0.50|
When the property is 50% occupied, the $2.50 that would be the Landlord’s costs shrink to $0.50 with the gross up provision.
Is This Just Good for the Landlord?
While the gross up clause seems to favor the landlord, it does protect the tenant from receiving significant bumps in the operating expenses charges each year. In the instance of a base year lease, the tenant pays only for their percentage share of the escalation above the base year costs. As long as the base year costs are also grossed up, the tenant shouldn’t experience a huge increase in their operating expense charges. This method also makes it easier for the tenant to budget for rent related expenses.
How the Weighted Average Occupancy Fits Into This
How do you know if the building is 95% occupied? It’s not simply a matter of comparing the total occupied square feet to the total rentable square feet at the end of the year. The percentage of time occupied also needs to be considered. This is where the Weighted Average Occupancy calculation comes into play. With each tenant, the percentage of the year occupied is calculated and then multiplied by the tenants proportionate share of the building. Thus if the 3,000 RSF tenant we saw at the beginning occupied the building from January 1 – September 30 we would take that into account for the total occupancy calculation.
The math looks like this: (3,000 RSF / 150,000 RSF) * 75% (occupied Jan – Sep) = 1.5%.
Tenant’s proportionate share of the building * Percentage of time occupied = Percentage contribution to the overall building occupancy for the year
The sample tenant would contribute 1.5 percentage points towards building occupancy for the entire year. Adding together that same calculation for the remaining tenants in the building will result in the Weighted Average Occupancy. And, if it’s less than the gross up percentage in the lease, then there’s further gross up work that needs to be done. If occupancy exceeds the gross up percentage, then the actuals are used for the operating expense estimates and eventually reconciliations.
 Holland & Hart has a good post on Gross Up Provisions. I borrowed the table above from their write up (with a few modifications).