True Confessions of a Landlord’s Counsel: What a Commercial Tenant Needs to Know When Negotiating a
Part 4: Additional Rent.
Additional Rent is a collection of all the various costs of operating a building and its surrounding property that a landlord charges a tenant, in addition to the “Base Rent” that the landlord charges for space within its building. Most commercial leases generally fall into one of two major categories, “triple net leases” or “gross leases”. The major difference between these two forms of lease is the manner in which they pass through to the tenant those costs (i.e., Additional Rent), which costs fall into three general categories, real property taxes, insurance, and common area maintenance expenses.
Triple net leases, which are named for these three categories of pass-throughs costs are commonly used in retail leasing. In triple net leases, calculating the tenant’s share of the landlord’s costs of taxes, insurance and common area costs are typically based on the tenant’s pro-rata share of floor space of its premises compared to all the floor space in the shopping center. (For example, if the total amount of floor square feet in the shopping center is 20,000 sq. and the size of tenant’s premises is 3,000 sq., then tenant’s share of the triple net costs should be 15%.) Each year a landlord will prepare an estimate of all the triple net costs for the calendar year and require the tenant to pay 1/12th of the estimate as Additional Rent on the first day of each month along with its Base Rent. There will then be a “true up” or “reconciliation” within three months after the end of each calendar year at which time the landlord will calculate the actual costs incurred during the previous calendar year, and either bill the tenant for any shortfall between the estimated cost paid and actual cost, or credit the tenant for any overpayment against the upcoming monthly Additional Rent payments.
Any tenant entering into a triple net lease should require a landlord to provide it with accountings for the last two or three years of costs that have been passed through to determine how consistent these costs have been. Landlords will typically increase the estimated costs for the upcoming year based on any increase in actual costs incurred during the previous year. Tenants should try to negotiate a percentage cap on any annual increase in the triple net costs (typically 3-5% per year, noncumulative) which would be applicable to all triple net costs, except those costs beyond the reasonable control of landlord, which typically include taxes, insurance and utility costs. Landlords generally also include in Additional Rent a property management fee of 10-15% of such triple net costs to cover the landlord’s overhead expenses for managing the vendors creating these costs. Tenants should attempt to exclude from the management fee the same items that are not applicable to the cap, i.e., taxes, insurance and utilities, since the only management landlord is doing is writing the check to timely pay these obligations.
Gross leases are more typically found in office and industrial leasing. In a true gross lease, the landlord charges the tenant a Base Rent for the premises and does not include any Additional Rent or pass-through costs as discussed above in the triple net leases, as the “gross rent” being charged has already factored in all these pass-through costs by the landlord. True gross leases are not commonly found anymore as landlords have incorporated into their leases many of the pass-through concepts found in triple net leases. If a landlord is willing to provide a true gross lease, it will typically be a very short-term lease, 1-3 years at most.
The more common gross lease is a “true gross lease” (at least for the first year) with annual adjustments to the “gross rent” determined by an increase in pass-through costs over the “base year” for the lease. This means that a landlord will charge a tenant just gross rent for the first full year of its lease, as this year will have factored into it all the pass-through costs from the previous year (which previous year is typically the “base year” for the purpose of calculating the gross rent adjustments). If after the first lease year the landlord’s pass-through costs for the Property in which the premises is located, exceeds the base year amount of these costs, then the landlord will increase the gross rent for the upcoming year by tenant’s pro-rata share of the increase of the actual costs in the last year over the base year. The gross lease with annual base year adjustments to gross rent is very similar to a triple net lease, except that there is no reconciliation to be paid by tenant if the actual pass-through costs were greater than that estimated into the gross rent charged by landlord, so landlord’s “true up” of any increase in costs is delayed for a year by adding this increase to the gross rent for the upcoming year. Similar to triple net leases, a tenant should attempt to put a percentage cap on the controllable costs (i.e., all pass-through costs excluding taxes, insurance and utilities), with respect to any annual adjustment to gross rent.
Another issue to consider when calculating Additional Rent is how the premises is being measured to determine tenant’s pro-rata share in either a triple net or gross lease situation. In retail, premises are typically measured from the outside of any exterior wall of the premises and to the middle of any common wall of the premises within building. In industrial/warehouse leases it is the same, except that instead of the outside of exterior walls, the measurement goes to the end of any roof overhang, which typically includes any overhang coverage at the loading docks. Office leases have a more unique and complicated system that was created by an organization called the Business Office Management Association (“BOMA”). The BOMA standards distinguish between useable space and leasable space of the premises. The leasable space includes common hallways and restrooms (but excludes floor space taken up by lateral support columns, ventilation systems, elevator shafts and stairwells, so as to take into account multi-storied office buildings). Useable space is just the space within the “four walls” of the premises that the tenant can actually use to conduct its business. In any of these situations, it is important that the tenant obtain assistance from its broker to make sure that the measurements of the premises are accurate, as well as the measurement of the total leasable area of the project, as it is leasable space that tenant’s gross rent will be determined, and it is tenant’s pro rata share of leasable space upon which any increase of pass-through costs over the base year will be calculated.
The nuances to various types of other pass-through costs of which a tenant should be aware will be discussed in the next few chapters of this series.