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Debunking the Myth – Repair Expense Gross-up?

Debunking the Myth – Repair Expense Gross-up?

Introduction/Summary

In the real estate industry some publications and bodies that cater to property owners and managers promote the concept that repairs and maintenance expenses such as light bulb changes replacements and tenant services requests are subject gross-up because they are provided to the tenant’s premises.  However, unless specifically stated in the lease agreements between the owner and the tenant, per QLoop standards, such repairs and maintenance expenses should not be subject to gross-up on those basis notwithstanding their possible variability with building occupancy fluctuations.

Terms and Terminology

Repair and maintenance expenses are costs incurred by the landlord to maintain and operate a property.  Repair refers to work done to correct a problem whereas maintenance refers to work done to service or inspect an item in order to ensure problems don’t occur to identify problems that may occur in the future. They include repairs and maintenance of a building, its common areas and its systems. They also include the repairs and maintenance of premises areas (carpet,  standard interior door repair/replacement, light bulb changes, tenant heating, ventilation and air conditioning [“HVAC”] systems, etc.).  Basically, repairs can be performed for the building or for the tenant.  If for the building, it would generally be included in building operating costs – to be allocated proportionately to occupied and unoccupied rentable areas of the property.  If for the tenant, it should generally be charged directly to the tenant and not made a part of building operating costs.

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.

Debunking the Myth

While repairs and maintenance expenses are generally seen as linked, the focus of this article is the “repair” aspect.  In order to understand why repairs expenses 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 repair expenses expenses fundamentally differ from cleaning costs and utility costs from the owner’s and tenant’s perspectives.

Cleaning and utilities services used by tenant are predictably, and consistently, measurable and have a direct proportionality relationship with occupancy.  Premises cleaning services, sometimes referred to as night-time janitorial services, costs are typically based on a cost rate multiplied by 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%.

Repair expenses are not predictably and consistently measurable by any stretch of imagination.  Unlike cleaning and utilities where the cost paid in a given month is correlated with the service provided in the given month, the timing of repairs have nothing to do with the period of usage of the items being repaired and has nothing to do with the occupancy levels at the time the work was performed.  For example, a HVAC system failure and repair in year 5 of its life could occur when a building is 1% occupied or 100% occupied.  Further, the failure and resulting repair may be due to excessive usage in years 1 to 4 of its life when the building was 100% occupied rather than due to minimal usage in year 5, when the failure and repair occurred, when the building was 50% occupied .

A repair performed in the premises of a tenant, for the tenant, should not be part of building operating costs and should be charged directly to the tenant unless the tenant’s lease prohibits it – in which case the landlord is still not permitted to charge it to operating expenses pool.

Another difference between repairs and cleaning or utility costs is the basis of the costs.  For repairs, the basis is indeterminable until a specific quote for the service is received from the contractor.  If based on hourly rate, the final cost would likely have no bearing on the premises size.  For cleaning and electricity, a common basis is service area (square feet cleaned) and service levels (kWh consumed), respectively.

The landlord’s objective is to ensure it can recover 100% of costs it incurs in operating a building.  It can accomplish this objective in two ways: (1) operate a fully leased and occupied building or (2) gross-up all expenses in a less than fully occupied building.  If the latter is possible, there is little-to-no incentive to attain full occupancy.   When a building is not fully occupied, and expenses other than the typical premises utilities and cleaning costs are grossed up, tenants should ensure that the lease explicitly calls for the gross-up of such expenses and that expenses which should be charged directly to the premises (vacant or occupied) are not included in the pool of operating expenses subject to gross-up.

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 or inaccurate occupancy records.  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 certain costs may prove challenging in as much the same manner that disputing a repair gross-up based on a poorly written lease can.  If the landlord’s ability to gross-up repairs and other fixed costs is limited, 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 repair costs.

Insights/Takeaways

  • The gross-up concept’s foundation is on occupancy fluctuations.
  • Repair expense gross-up is inappropriate despite its possible fluctuation with occupancy because it has an added characteristic that differentiates it from “true” occupancy variable costs in that it is not predictably and consistently measurable and could have an inversely proportional relationship with 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 repair expense gross-up myth, result in landlord and tenant disputes over its application and increase the tenant’s economic exposure.

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