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Lease Audit Articles

Why Should Expenses Be Grossed Up

Critical to the fair implementation of a base year structured lease is the gross-up concept, also known as extrapolation.  A gross up provision allows – in fact, requires – the landlord to increase those categories of operating expenses which are affected by changes in occupancy to reflect what such costs would have been if the building had been fully occupied (the lease will typically define "fully occupied" to mean either 95% or 100% occupied).  This will ensure the tenant's "base year" expenses are reflective of a highly or fully occupied building and will protect the tenant from large increases in its operating expense obligations caused by increases in the building's occupancy.  For example, if a tenant's base year is established during a year with low building occupancy, lacking a gross up provision the base year costs will only reflect the costs incurred for running a partially occupied building.  If later the building is more fully occupied, the tenant would be responsible for paying its pro rata share of the increased expenses resulting from the higher occupancy level.

Similarly, costs that would have been incurred during the base year but, instead, were covered by a warranty should be included in the determination of the base year's expenses.  For example, in a new building if the elevators are covered by warranty during the base year, the landlord's actual cost incurred for elevator maintenance during the base year would be $0.00.  In the first comparison year, however, the warranty has expired and the elevator maintenance costs total $60,000.  In such a scenario the tenant's operating expense obligations are inappropriately impacted by the $60,000 difference.  Consequently, the base year expenses should be adjusted as if elevator maintenance costs existed during the base year and the landlord should determine what the costs would have been if no warranty applied.  In this case, if the elevator contract has a 5% rate increase from year to year, then the base year elevator expenses should have been 5% less than the first contract year, or $57,000.  In other words, by implementing this "warranty" provision, the tenant would only be responsible to pay for its share of the $3,000 increase (i.e., $60,000 - $57,000 in the base year), as opposed to being required to pay for its share of the full $60,000 every year during the lease term.

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