Understanding Pass-Through Expenses.
Pass-through expenses is one of the most common questions we get in Commercial Real Estate, and it’s a topic that many tenants don’t approach until they under a lease agreement and have received an unexpected bill from their Landlord. Here, we will explain what constitutes pass-through expenses, who is responsible for which expenses, and use some examples of common lease scenarios to help better explain those expenses and how they would work.
On the most basic level, pass-through expenses are property costs that the Landlord passes through to the tenants of that property. Or even more simply, any expenses that are not the base rent. Those can expenses typically include: Common Area Maintenance (better known and seen as just CAM for short), property taxes, and insurance, utilities, and janitorial (if it applies), and they are passed-through based on a tenant’s SF percentage occupancy of the whole property. Meaning, if a tenant is occupying 10% of a building, their pass-through expenses would typically be 10% of the total
Which expenses are passed-through to a tenant often depends on the structure of the lease and whether the lease is defined as a Triple Net, Modified Gross, or Full Service (sometimes also called a Gross Lease).
In a Triple Net lease, all expenses are passed through to the tenant: CAM, property taxes, insurance and you are also separately responsible for utilities and janitorial. Tenants in a NNN lease will typically see these bills and expenses starting as soon as their lease starts.
In a Modified Gross or a Full Service lease, the expenses just discussed (CAM, taxes, and insurance) are typically already estimated and included in the rental rate. In the first year of the lease, often called the Base Year, tenants typically will not be billed for any additional pass-through expenses. However, in the second year of the lease, tenants may begin to be billed for pass-through expenses, as the amounts for CAM, taxes, and insurance went up above the previous year. It is important to note that pass-through expenses may fluctuate, but you will only owe for any amount over the Base Year.
Modified Gross or Full Service leases are where pass-throughs can get more confusing and where most Tenants are surprised by their pass-through bills. So here’s an example to help break it down further.
In this example, you moved into your new space in January 2019, you are under a Full Service lease, and you occupy 10% of the building. You pay your set monthly rent payments, which covers all of your rent, CAM, taxes, insurance, janitorial and utilities. The expenses for the building in 2019 were $100,000, and since you occupy 10% of the building, your rent payments covered that $10,000.
However, if the 2020 estimated expenses for the building increase to $105,000, then with your January 2020 rent payment, the Landlord would invoice you for your portion of the $5,000 increase split over 12 months, which comes out to an extra $41.67 per month. At the end of the year, if the actual expenses were less than that $5,000 estimated increase, then the Landlord will give you a credit against your next months balance. If the actual cost is more than the estimated amount, then you will owe the difference.
So with this example and pass-through expenses, we often see the same questions come up, and they are:
1: If I am paying an escalation on my rental rate, why doesn’t the escalation cover these increases in operating expenses? And the shortest simple answer is that it isn’t the way these lease structures are typically handled.
2: What happens if expenses go down as compared to my base year? If this happens, it is money the Landlord gets to keep. It also incentivizes the LL to keep costs low.
3: How do I limit these costs going up unexpectedly? We recommend that you either A: Put a cap on the annual increases in controllable expenses or B: Have language in your lease stating that capital improvements (not repairs) are excluded from expenses passed through to tenants.
And one last item to note regarding pass-throughs…with buildings being purchased and sold and values increasing, it is important to note that when your building sells, it is likely that the taxes on that property will increase and the cost might be passed on to you as a tenant.
Helping understand and negotiate pass-through language is only one of the many ways Cecil & Campbell can help you negotiate your office lease and add value to your business. We would be honored to help you and as always, please feel free to reach out with any questions you may have.
Cecil & Campbell Advisors is a commercial real estate advisory firm headquartered in Atlanta, Georgia – specializing in investments, acquisition & disposition, and tenant representation of commercial space.