Editor’s note: this is an edited article originally written by Rick Burke of Lease Administration Solutions, LLC. If you’d like to read the original, visit NRTA’s Professional Library.
Mixed-use buildings that combine business, manufacturing, or residential usage have always been appealing to landlords, but the pandemic has heightened that interest. While tenants face bankruptcy because of COVID-19, landlords utilize these buildings to increase the rental income and appreciation while diversifying their portfolio. In addition, retailers have discovered a new customer base as Boomers sell their homes and move to mixed-use condominium living.
Customers often enjoy the convenience of one-stop shopping without having to drive several miles to the mall, but mixed-use buildings have a disadvantage. The building’s setup requires a unique allocation of occupancy costs among the tenants. Even the most experienced landlords may struggle to keep matters fair. Many of the overcharges found in lease audits are a result of the differences between retail and office lease language or industry practice.
Leased Space Configuration
This configuration presents a basic difference between an office and a retail lease. Retail space is mostly horizontal and, when expanding, builds on the original space. Retail space is based on leasable or occupied square footage and excludes lobbies and common areas.
Meanwhile, office space is vertical and can have several individual, separated suites that roll up into the total square footage for a lease. These suites may have different occupancy cost exclusions, base years, and rights. Office space may be stated as rentable square footage and include common areas and lobbies. The complexity of allocating costs to multiple office suites can often result in overcharges for both the office and retail tenants.
Additional Fees, or Pass-Through Costs
Pass-through costs refer to charges against a tenant that go beyond rent, such as common area maintenance fees, taxes, and insurance. In most situations, retail tenants often pay their own utilities, cleaning, and HVAC maintenance directly to the vendor. Due to the uniqueness of a mixed-use building, however, these expenses are frequently paid directly to the landlord.
Here are some major areas to consider:
- To avoid double payment, tenants should verify if credit for any pass-through cost was already taken out for the common area maintenance/operating expense statement.
- Office tenants usually pay more in overtime electricity usage, which could end up as a double payment if not credited against the operating statement.
- Office tenants often pay for parking on a per space basis. These tenants must verify that there are no additional parking expenses such as insurance, cleaning, R&M, or real estate taxes on the operating statement to avoid double payment.
- Office leases often include a Base Year clause where minimum rent accounts for a certain level of pass-through costs. On the other hand, most retail leases are triple net, where utilities, real estate taxes, and insurance is paid separately from rent. Retail tenants pay 100 percent of their pro-rata share of these expenses for any stated period.
- For more information, visit NRTA’s retail term glossary.
- Office leases usually calculate a base rent based on the operating expenses or real estate taxes for the first year of the lease. Because it is in the landlord’s best interest to have a low base year, the tenant should audit the base year early in the lease term.
Discussing the Gross-Up Clause
A gross-up, or extrapolation method, is unique to office leases. If stated in the lease, the landlord can extrapolate operating expenses based on a stated percentage occupancy level in the building. The gross-up clause kicks in when the building is not fully occupied. This is common in new buildings. If a lease allows a landlord to gross-up to a stated 95 percent occupancy level, and the building’s current occupancy level is less, then the landlord can increase the operating expenses as if the building were occupied at the 95 percent level. However, not every operating expense account is “grossed-up.” Only variable expenses that change with the level of occupancy should be adjusted.