In a gross commercial lease, you'll usually pay a single fixed fee every month that covers your rent and all related operating expenses. If you're sure that your business will be paying a fixed rate for the space and that you'll owe the landlord no additional charges, the rent clause in the landlord's lease ought to be fairly simple.
But there are a few important issues that could affect your rent payment pursuant to a gross commercial lease:
When reviewing your commercial lease, the trickiest issue to consider is how the landlord has measured the space. If the space has been measured from the exterior of outside walls with no deduction for the thickness of interior walls, you're paying for a lot of plaster.
It's prudent to measure the space yourself to confirm the landlord's figure. Clearly, if there's a significant difference you'll want to raise the issue during negotiations.
In anticipation of inflation, some landlords want the rent to increase year to year according to some formula. Sometimes the increase is flat and clear, such as an increase of $0.20 per square foot (sq. ft.) per year.
Another way landlords calculate the yearly rent increase is by tying it to the Consumer Price Index (CPI) for your region. The CPI measures how prices for goods and services change over time. Every month, the U.S. Bureau of Labor Statistics posts national and regional CPI averages both for all consumer items and for specific consumer items, such as:
With this approach, the percentage of CPI growth is applied to the base rent. Your lease should specify which CPI statistic is used to calculate your rent increase—whether national or regional and whether for all consumer items or for a specific consumer item.
For example, suppose your lease says that your rent increase will be adjusted each month by the national CPI for all consumer products. So, if the national CPI for all consumer goods goes up by 5%, your rent will also go up by 5%.
But there are some drawbacks to basing a rent increase on the CPI.
If your rent increase is based on CPI growth, it can turn out to be very expensive for you. There's no guarantee that the value of the building will increase at the same rate as the CPI.
And if the rate of inflation is high, the CPI might be way ahead of your ability to make a profit in your particular business. Specifically, if your CPI is based on the national average but your geographic area is experiencing slower economic growth, you might be at a bigger disadvantage.
If your landlord insists on using CPI to calculate yearly rent increases, bargain for CPI numbers specific to your region. You don't necessarily want to use the CPI for Los Angeles if your business is located in Charleston, South Carolina. If your region's CPI is drastically different from the CPI your landlord is proposing, you should be able to reasonably argue that it would be fairer to use your regional CPI.
Another drawback to using the CPI as the rent escalator is that you'll never know how high the rent can go unless there's a limit or "cap." In fact, a CPI-based rent escalator should have both a ceiling and a floor (also known as a "collar"). Why? Let's look at it from your point of view.
Suppose you want to take out a business loan to cover the expense of a new computer system for your office or a piece of equipment for your shop. Your lender will want to know what your expenses and income are likely to be during the life of the loan (that'll give the lender a good idea about whether you'll be able to repay it). Now, if there's no cap on your rent, the lender might worry that your rent could become so expensive that you wouldn't be able to meet your repayment obligations. And if the lender is worried enough, they could deny the loan.
For this reason, you should negotiate for a ceiling to the rent—no higher than you could comfortably afford. Point out to the landlord that the ceiling might never be reached. It'll likely satisfy your potential lenders, which benefits the landlord as well. (You can reasonably argue that a thriving tenant with sufficient capital is one who pays the rent on time.)
Don't be surprised if the landlord counters with a demand that you agree to a "floor," which will guarantee a minimum rent in case the CPI decreases. Echoing your reasoning, the landlord might argue that without a minimum rent, lenders could worry that the landlord too might not have the income to repay a loan.
You might have to settle for a compromise: You get a cap, and the landlord gets a floor.
Example: Suppose Landlord Spiffy Properties LLC and tenant Protobiz Inc. agree that rent increases will be tied to the annual changes in the CPI for their metropolitan area. They also agree that Spiffy will get at least a 2% increase each year (the floor) and that Protobiz won't have to pay more than a 4% increase (the ceiling). One year the CPI increase is 5%. Protobiz has to pay for only a 4% increase—the cap (or ceiling) agreed to in the lease.
In many buildings, you'll share parts of the structure or grounds with other tenants. For example, you and other tenants might share hallways, lobbies, elevator shafts, bathrooms, and parking lots. Added up, these spaces can amount to a hefty chunk of the property. The landlord usually won't let you use these shared facilities for free.
Instead, the tenants will normally share the cost of these common areas. Landlords will sometimes charge individual tenants for a portion of the common space by using either a loss factor or a load factor. (Many times the loss factor is also incorrectly referred to as the load factor.)
Depending on which method the landlord uses, you could either:
If the space is wide open and easily divided into rentable pieces of varying sizes—such as a new office building with no interior walls in place yet—the landlord might apply the loss factor. They could advertise one size (for example, 800 sq. ft.) but actually turn over a smaller space (say, 600 sq. ft.) to the tenant.
Using this method, the landlord is actually counting part of the common area's square footage as your own personal square footage in your rent calculation.
For example, suppose a landlord has a 5,000 sq. ft. space. In the space, 1,000 of the 5,000 sq. ft. is taken up by common areas, such as bathrooms, hallways, and a lobby. The remaining 4,000 sq. ft. can be subdivided among the tenants. In this scenario, the loss factor would be 1,000 sq. ft. of common area divided by the 5,000 sq. ft. of total space, expressed as 20%.
The landlord advertises five 1,000 sq. ft spaces to rent—adding up to the entire building's space of 5,000 sq. ft. but exceeding the private space available to tenants, which is 4,000 sq. ft. To decide how much space within the available 4,000 sq. ft. to section off for each of the five tenants, the landlord would:
The resulting number would be 800 sq. ft. So, each tenant would have 800 sq. ft. of private space but pay for 1,000 sq. ft. of space as part of their rent. The landlord would count 200 sq. ft. of the common space as part of each tenant's total square footage.
If the space in the building is permanently divided into rentable lots, as is true in an older, multi-tenant retail space, it's likely that the landlord will use the load method. This technique is generally used when the square footage for each space can't be reduced without major reconstruction.
Using the load method—rather than reducing your amount of usable space—the landlord tacks on an additional charge for the tenant's proportional share of the common areas.
For instance, assume in our previous example that the lots are permanently divided—that is, the landlord has already put up walls dividing the space up. As before, the landlord has a 5,000 sq. ft. space with 1,000 sq. ft. of common areas. The remaining 4,000 sq. ft. of private space has already been divided into four 1,000 sq. ft. lots that can't be reapportioned. So, the landlord advertises four 1,000 sq. ft. spaces. To account for the 1,000 sq. ft. of unrentable, common areas, the landlord passes on the rent for the common areas to the tenants.
To calculate how much extra each tenant should pay, the landlord divides the 1,000 sq. ft. of common areas by the 4,000 square feet available for private use. So, the landlord must increase each tenant's rent by 25% to cover their proportional share of the common area.
If you need the full square footage as advertised or represented by the broker and anything less won't work for you, make sure the landlord doesn't apply the loss factor. The loss factor will decrease your usable space. For example, if you need a full 1,000 sq. ft., you don't want to learn that the loss factor will be used to charge you for that size but actually deliver less, say, 800 sq. ft.
If you can't settle for less space, you'll prefer to have the landlord use the load factor, which will result in you getting the full 1,000 sq. ft. but being charged for more. Raise the issue early on.
Be aware that you might not always be informed of the loss or load factor in your first dealings with the landlord—you might not see it in the ad, for example. But the broker (if there's one involved) will probably know if either factor is operating behind the scenes. They should be able to help you compute the true cost of the space.
Your gross lease in a multi-tenant building might include a provision allowing the landlord to begin charging you when operating costs rise above a certain level. In this case, the landlord will probably include a gross-up clause if the building isn't fully occupied during your base year. The gross-up clause ensures that you pay only your fair share of any increased costs. Here's why this clause is necessary, and how it works.
Suppose you rent one entire floor of a 10-story building, but the rest of the building is vacant. The lease provides that when electricity usage rises above the cost in the first year, you begin to pay 10% of the excess. In the first year, the bill is $100,000, so that becomes the base year. Now, assume that in the second year, all floors are occupied and everyone uses the same amount of electricity so that the bill for the second year is $1,000,000. Since that's $900,000 more than the base year amount, you'll begin paying 10% of $900,000, or $9,000—even though your usage hasn't changed.
The way to remedy this problem is to figure the base year number as if the building were fully leased, with everyone using the same amount of electricity. Assuming the same building as above, to "gross up" the base-year figure, you'd ask the landlord to make the base-year electricity number $1,000,000 (10 stories of 10 tenants, each using $100,000 worth of electricity). Under this scenario, in the second year, when the entire building is occupied, you won't pay for any increase in the utility cost because the bill for the entire building isn't over $1,000,000.
Grossing up is appropriate only for variable costs, such as:
Fixed costs, such as the cost of insurance and property taxes, which don't vary depending on building occupancy, don't require grossing up.
While a gross lease usually involves a flat fee paid monthly, a lot of factors go into calculating that fee. Your rent could be simple and straightforward—your space is measured by the interior walls, your rent escalation is constant and manageable, and the landlord doesn't use the loss or load factors.
But if your landlord uses a complicated system to calculate your rent and you think you could be charged unfairly, you should speak with a real estate lawyer that has experience negotiating commercial leases. They've likely dealt with both the loss and load factors, and have an understanding of calculating rent escalation. An attorney can help you negotiate the best terms in your lease and help you plan for any foreseeable rent increases.