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Debunking the Myth – Management Fee Gross-up?

Debunking the Myth – Management Fee Gross-up?

Introduction – Management Fee Gross-up Myth

In the real estate industry the prevailing view, a myth, is that premises management fees, in addition to true occupancy-dependent premises cleaning costs and premises Utilities costs are the three primary building Operating Expenses subject to the gross-up adjustment solely because the costs of all three typically vary with building occupancy fluctuations.  However, unless specifically stated in the lease agreements between the owner and the tenant, per QLoop standards, management fees should not be 100% subject to gross-up notwithstanding their variability with building occupancy fluctuation.

Terms and Terminology

Management fee is a form of compensation paid to a property manager, by a building owner, for the management and operation of a property on the owner’s behalf.  The management fee is typically calculated as a percentage of revenues from building rents.  Depending on the market the fee represents, at a minimum, profit and overhead costs of the property manager.   Gross-up is a cost allocation concept applied to specific building operating costs incurred in the operation of partially occupied properties.  The primary objective of the gross-up adjustment is to ensure that specific building operating costs which vary with occupancy are fairly allocated to the consumers of the services that contributed to the costs, such that, in a 100% gross-up scenario for example, a 50% occupant tenant of a 50% vacant building will be responsible for 100% of those specific costs resulting from the occupant’s use.

Management fee gross up calculation requires the use of estimates.  The gross up objective is to determine a “fair” value of full building costs, in a partially occupied or fully vacant building.  As such, the gross-up approach relies on occupancy information and the identification of cost pools which change when occupancy changes.

A management fee myth exists when one party exploits these common differences in order to overstate or understate the fee.

Debunking the Myth

In order to understand why management fee gross-up is inappropriate, it is important to know the reason gross-up of premises cleaning and premises utilities costs are permissible.  It is also important to understand how management fees fundamentally differ from cleaning costs and utility costs from the owner’s and tenant’s perspectives.

Cleaning and utilities services used by tenant are predictively and consistently measureable.  Premises cleaning services, sometimes referred to as night-time janitorial services, costs are typically based on the size of the areas being cleaned.  As such, in a situation where the owner of the 50% vacant building with a 50% tenant occupant has employed a cleaning contractor who is paid $50,000 to cleaning occupied areas, it is only fair for the tenant to be responsible for 100% of the $50,000, rather than a 50% share (or $25,000) of the $50,000.  As such, the owner grosses-up the $50,000 to $100,000 to represent what the costs would have been had the building been 100% occupied and then submits an invoice to the tenant for its 50% share of the $100,000. The critical point here is that the tenant’s space was actually cleaned and for a cost of $50,000.  If the tenant’s cleaning requirements and service levels increase or decrease, there will be a direct noticeable increase or decrease in the costs.  Likewise, with respect to premises utilities, the utilities costs are dependent on the tenant’s activities and usage levels.  The lighting, computing and other utility consumption costs are directly tied to the tenant’s level of usage.  As such, there will be a noticeable and directly proportional fluctuation in premises utility costs within the same accounting period when the building occupancy changes from 50% to 100%.

The fundamental difference between management fees and cleaning or utility costs is that management fees do not result from tenant consumption which is the foundational basis for the gross-up concept that requires that tenants pay their fair share of the services received.  However, a review of a contract between the property manager and the owner would reveal that the services provided by the property manager for the landlord and the building common areas significantly outweighs the services performed directly for the tenants.  With cleaning and utilities, the services are purely for the tenant spaces.

Another difference between management fees and cleaning or utility costs is the basis of the costs.  For management fees, the basis is building rental revenue, whereas for cleaning and utilities, the basis is service area (square feet cleaned) and service levels (kWh consumed), respectively.  Neither the rent nor the management fee rate and the resulting fee has any bearing on services delivered to, or received by, the tenant, in the same manner that premises utility and cleaning costs do.  Further, the management fee does not correlate with the manager’s abilities, activity levels or services and no property manager can claim that, with each increase in management fee directly due to an increase in a tenant’s rent, through escalation or otherwise, there is a preceding and correlating physical uptick in tenant services.

Property managers are agents of the owner with primary fiduciary obligations to the owners.  As such, it is not surprising or prohibited for the owner to align the property manager’s interests with its own interests via a revenue-based incentive compensation called the management fee.  However, without discounting the significant value of a property manager to a building’s operation, it is important to understand the owner-manager alignment in the implementation of the gross-up concepts.  The manager performs a service for the owner. The utility and cleaning companies perform premises services for the tenants. The management fees paid to the manager should not be subject to gross-up in the same manner that premises cleaning and utilities costs should.

Practical Applications

The lease agreement between the owner and the tenant is the most critical document for ensuring the proper application of a gross-up concept.  First, the lease has to indicate that a gross-up is permissible and should specify the occupancy threshold (100%, 95%, 90% 85%, etc.) that will trigger the gross-up application.  Each threshold should be determined in coordination with the owner’s and the tenant’s representatives paying particular attention to the building’s history of occupancy.  A building that has a 10-year history of 95% occupancy should not command a 100% gross-up threshold as it may actually have “dead” or permanent remnant spaces due to improper space configurations throughout the building.  Second, the lease should specifically state the costs that are subject to gross-up rather than leave it to individual interpretations which may be influenced by long-perpetuated myths.  Third, the lease’s gross-up provision should except management fees, fixed, common area and general building costs from being subject to gross-up in instances where additionally certainty may be required.

Challenges

The gross-up concept allows the landlord to recover certain, select, costs which occur and therefore fluctuate, as a result of a tenant’s occupancy.  The landlord benefits from including more costs in the gross-up pool and will resist modifications to the lease that will limit its ability to do so.  As such, negotiating out a management fee cost may prove challenging in as much the same manner that disputing a management fee gross-up based on a poorly written lease can.  If the landlord cannot gross-up management fees, it could result in a greater oversight and pressure on the property manager to increase building occupancy so as to defray the unrecovered portions of the fee.


Insights/Takeaways

  • The gross-up concept’s foundation is on occupancy fluctuations.
  • Management fee gross-up is inappropriate despite its fluctuation with occupancy because it has an added characteristic that differentiates it from “true” occupancy variable costs in that it fluctuates primarily with leased tenancy (economic occupancy) rather than physical occupancy.
  • Leases should be structured to clearly reflect the gross-up concept by specifying the appropriate cost pools, occupancy thresholds and clarifying exceptions to the gross-up calculations.
  • Poorly negotiated or structured gross-up clauses could add to perpetuate the management fee gross-up myth, result in landlord and tenant disputes over its application and increase the tenant’s economic exposure.

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