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Commercial Leases – Allocation of Operating Costs

If you have ever negotiated a commercial lease, you have heard the terms “gross” and “triple net” as they apply to allocation of expense obligations. Basically, a “gross lease” is one under which the Landlord is responsible for the basic operating expenses for the leased property such as real estate taxes, insurance, and maintenance, and the Tenant is required only to make a single monthly “gross” rent payment. On the other hand, a “triple net” lease or a “net lease” is one under which the tenant is required to pay or contribute to the operating expenses of the leased property in addition to paying a fixed base rent.

While a “gross lease” can include additional tenant obligations and must be reviewed carefully to ensure the parties understand their respective costs, a “net lease” can pose numerous interpretive challenges and questions. What constitute operating expenses? How are those expenses allocated among multiple tenants? How and when are those expenses to be paid and is there a cap on increases? What procedure is established for an accounting of the expenses?

While operating expenses are often referred to as “Common Area Maintenance” charges or “CAM”, they are generally not limited to common areas. For instance, they generally include real estate taxes for the entire property, and insurance for the entire building. They may or may not include utilities depending on whether those are separately metered to each tenant space in which case tenant may be billed directly. A clear definition of what is to be included in the operating expenses is essential both for landlords and tenants in order to avoid disputes. And once the operating expenses are clearly defined, any prospective tenant must be sure to do its due diligence and ask for actual expenses incurred in prior years in order to be sure the tenant has properly budgeted.

When there are multiple tenants, the parties to the lease must be sure to understand the allocation of expenses among those tenants. Generally, each tenant is assigned a percentage interest of those expenses, most often based on the relative square footage each tenant’s leased space bears to the total leasable space at the property. But landlords may seek to capture some proportion of expenses allocated to unleased portions of the property, particularly in larger projects, and tenants should be wary of such provisions.

Payment terms for operating expenses can vary but most often are estimated monthly payments made together with base rent payments and based upon estimates devised by the landlord. Less frequently, contributions to real estate taxes or insurance may be timed to the landlord’s due date for such payments. In either event, the tenant must understand the payment scheme and budget accordingly. Similarly, attention should be paid to any provision for adjustments in those expenses in the event there are increases, or in the rare circumstance decreases. An astute tenant will seek to negotiate a cap on increases, while a landlord may want to avoid such a cap for expenses that are largely outside its control, such as real estate taxes and insurance premiums.

Finally, when payments are monthly based on estimates, there should be an annual accounting which addresses actual expenses and adjusts accordingly between the landlord and its tenants in the event the actual expenses reveal the estimated payments already collected constitute either underpayments or overpayments. Such provisions should include a procedure for full disclosure, opportunities for review, and a mechanism for resolving disputes.

Whether you are a prospective landlord or tenant, make sure to discuss the lease terms with your attorney prior to signing anything in order to ensure that you fully understand your obligations. Any questions? Don’t hesitate to contact Tom Rickart at tel:(203) 902-4882.