Operating Expenses: Overlooked Concepts to Consider in Triple Net Leases

Feb 13, 2019

By Erin G. Howshar and Serena Sayani | Related Practice: Real Estate

Under a Triple Net Lease, the Tenant bears the cost of all operating expenses, taxes and insurance which are allocable to the Premises. Triple Net Leases are advantageous to the Landlord because they allow the Landlord to have certainty with regard to its income stream. These types of Leases are advantageous to the Tenant as well because the Tenant does not overpay for expenses since it is only paying the actual amount of the operating expenses.Office building

The Landlord’s objective in a Triple Net Lease is to obtain true net rent and not pay any operating expenses. Notwithstanding the Landlord’s objective, the items that make up operating expenses under the Lease are still a source of much negotiation.

Two overlooked provisions with respect to operating expenses that should be considered when negotiating Triple Net Leases are (1) the “Gross-up” clause, and (2) Tenant’s audit rights. Both concepts create benefits to the Landlord and the Tenant through economic certainty and transparency in the lease administration.

1. The “Gross-up” Clause

If the building is new construction or not fully rented, then the impact on the allocation of operating expenses can be dramatically skewed by the unoccupied spaces. “Gross-up” clauses are intended to address and eliminate the inequities resulting from vacancies by requiring Tenants to pay an equitable portion of the variable items of operating expenses. A typical “Gross-up” clause is below:

“If the Building is less than ninety-five percent (95%) occupied throughout any calendar year of the Term, then the actual Operating Expenses for the calendar year in question which vary with occupancy levels in the Building (e.g., utilities, janitorial, elevator maintenance, management fees) shall be increased to the amount of Operating Expenses which Landlord reasonably determines would have been incurred during that calendar year if the Building had been at least 95% occupied throughout such calendar year.”

So what does that look like in terms of economics? Assume that a Tenant occupies 10% of the rentable space in the building, and that variable operating expenses are $100. If the building is 100% leased, then the Tenant will pay $10 of the variable operating expenses, other tenants will pay the remaining $90 variable operating expenses, and the Landlord will pay $0.

Now assume the property is only 50% leased and the variable operating expenses are $50. The Tenant would pay $5, other tenants would pay $20, and the Landlord would pay $25.

Now assume that the “Gross-up” provision outlined above is in the Lease. The variable operating expenses would then be grossed-up from $50 to $95. The Tenant would pay $9.50, other tenants would pay the remaining $38 of variable operating expenses, and the Landlord would pay $2.50. This is illustrated in table form below.


% Leased 

Amount of Variable Costs

Tenant's Share

Other Tenants' Share

Landlord's Share

100%

$100

10%=$10

90%=$90

$0

50% (without gross-up)

$50

10%=$5

40%=$20

$25

50% (with gross-up)        

$95*

10%=$9.50

40%=$38

$2.50

*Amount of Variable Costs is Grossed-Up from $50


The “Gross-up” provision in the Lease is clearly economically advantageous to the Landlord since the Tenant is paying a greater share of the variable operating expenses. However, there are also advantages to the Tenant if it has a Base Year Lease since the Base Year without “Gross-up” would be extremely low. If the Base Year is grossed-up, then it protects the Tenant from dramatic increases in operating expense reimbursements from year to year.

2. Tenant Audit Rights 

In most jurisdictions, audit rights are contractual and are not a statutory right. Sophisticated Tenants will require the Landlord to grant them the right to audit the Landlord’s records relating to operating expense reimbursements. Landlords will often allow the Tenant to conduct these audits, subject to certain limitations, which may include the following:

  1. Limitation on time for initiating audit to a specific period of time after receiving the Landlord’s reconciliation statement. Landlords should also be sure to include a provision in the Lease that states that a failure to timely object is considered a deemed approval of the reconciliation statement.
  2. Limitation on time frame for completing the audit for a specified period of time after receiving the Landlord’s reconciliation statement.
  3. Limiting the location of the audit to the Landlord’s offices during regular business hours.
  4. Limiting the identity of auditors to the Tenant, its employees, and its accountants. This may prohibit third-party contingent auditors.
  5. Limitation on number of audits, typically to one per year.
  6. The Landlord may require no Tenant defaults in order to have an audit right.
  7. The Landlord may require the Tenant to pay all amounts owing on the reconciliation during the pendency of the audit.
  8. The Landlord may require the Tenant to keep the results of the audit confidential.
  9. The Landlord may require the Tenant to share the detailed audit results with Landlord.

The question of who pays for the audit is highly negotiated. Landlords may want the Tenant to bear all costs of the audit since it often delays the Landlord’s receipt of reconciliation funds and requires the Landlord to incur fees for its own accountants and staff time related to allowing the Tenant access to its books and records. Tenants will not want to pay for the audit if they determine that the Landlord has not properly accounted for the operating expense reimbursements and has overcharged the Tenant. In the event that the audit reveals a difference in the amounts charged to the Tenant over a certain percentage in the Tenant’s favor, then the Landlord may agree to split the audit costs with the Tenant or pay all audit costs.

When the Tenant is paying for operating expense increases over a specified Base Year, Tenants would be wise to request a right to audit the operating expenses for the Base Year. Landlords should be careful to include a time limitation on the Tenant’s right to audit the Base Year so that future audits are limited to an audit of the operating expense increases over the Base Year.
If you have specific questions regarding adding these provisions to your leases, contact a member of the Stokes Lawrence Real Estate group.