Base Year and Expense Stop: What They Mean for Your Rent

A gross or modified gross rent includes some level of building operating costs. If the lease is for several years, those costs will change. Base years and expense stops are the two common ways of deciding who bears the change. Holland & Hart describes the mechanism: the landlord passes through the amount of operating expenses in excess of the expense stop or base year amount.

Above the line, you pay your proportionate share. Below it, the cost is considered covered by your rent. Neither device limits how far above the line costs can go, so neither gives you a fixed occupancy cost. A triple net lease has no line at all, and the tenant pays its share from the first dollar.

The lease names a calendar year. The building’s actual operating expenses for that year become the baseline. Some leases use the year of signing or the year before, and Holland & Hart describes it as typically the first year of the lease. Yours may be different, so read it.

The figures below are hypothetical, for illustration. Take a 5,000-square-foot tenant in a building whose base year costs are $10.00 per square foot.

• Base year: costs of $10.00. You pay nothing above rent.
• Next year: costs of $10.60. You pay $0.60 times 5,000, or $3,000.
• The year after: costs of $11.20. You pay $1.20 times 5,000, or $6,000.

The baseline stays where it was set, so each year’s bill is measured against the base year, not the previous year.

An expense stop sets the line as a stated amount per square foot instead of a year’s actual costs. That amount is treated as the operating expense component built into the rent. You pay your share of expenses above that amount.

Using the same hypothetical tenant and costs, assume a stop of $9.50.

• First year: costs of $10.00 are above the stop, so you pay $0.50 times 5,000, or $2,500.
• Next year: costs of $10.60. You pay $1.10 times 5,000, or $5,500.
• The year after: costs of $11.20. You pay $1.70 times 5,000, or $8,500.

So the tenant owes pass-throughs from the first year if the stop is set below actual costs. A stop set above actual costs delays them. That single number can be worth more than a rent discount, so you should ask how it was chosen and compare it with the building’s recent actual costs. A stop can look generous only because you have not seen the current expenses.

Whichever device a proposal uses, ask for the same thing: the building’s actual operating costs for each of the last several years, per rentable square foot.

Many costs change with occupancy. A half-empty building has less cleaning and uses less electricity. Without an adjustment, a base year set during low occupancy would produce a low baseline, and you would pay increases as the building fills, even if prices never rose.

A gross-up clause addresses this by restating variable costs as if the building were fully or nearly fully occupied. Holland & Hart notes that a tenant with a base year can actually benefit from it, since it raises the expense stop for later years and protects the tenant from a spike in operating expenses. Here is a hypothetical, for illustration.

• A building is half occupied in the base year. Fixed costs are $6.00 per square foot and variable costs are $4.00, for a total of $10.00.
• Without a gross-up, the baseline is $10.00.
• Later the building fills. Variable costs double to $8.00, so total costs are $14.00, with no change in prices. A 5,000-square-foot tenant pays $4.00 times 5,000, or $20,000, for the increase.
• With a gross-up, base year variable costs are restated to $8.00 and the baseline is $14.00. The same tenant pays nothing for this increase.

There are limits to keep in mind. Only costs that vary with occupancy should be grossed up. Fixed costs, such as taxes and insurance, should not be, and Marks Paneth’s Eduard Suleymanov makes that point. The base year and comparison years should use the same method. Holland & Hart adds that the tenant should not pay amounts in excess of what the landlord actually pays, and should be able to review the calculation. It also notes the occupancy level, such as 75 or 80 percent as a compromise, can be negotiated.

If costs are rising, a later base year gives you a higher baseline and smaller pass-throughs throughout the term. A lease that starts late in a calendar year illustrates this well.

Take a lease that begins in November. If the base year is the year the lease starts, your rent has covered barely two months of that year when you begin paying increases over it the next January. If the base year is the next calendar year, you pay no pass-through until the year after that, and your baseline is set by a year when you are actually in the building. A base year set by the year of signing or the preceding year can fall even further from your actual occupancy.

Other factors to look at include these.

• Abnormal base years. Unusually low taxes because of a pending appeal, or waived costs, can understate the baseline. Ask whether later tax refunds reduce it.
• Separate lines. Taxes and operating expenses may use separate base years or amounts.
• Items that appear later. A cost not in the base year, such as a new amenity or a new category of insurance, can produce an increase with nothing to measure it against.
• Renewals. A renewal is a chance to reset the baseline to a current year. Do not let it carry over without asking.

• ✓Is it a base year or an expense stop, and what is the year or the amount?
• ✓What have actual operating costs been for each of the last several years?
• ✓Is the base year or stop grossed up, and to what occupancy level?
• ✓Do later years use the same gross-up method and the same categories?
• ✓Do taxes have a separate base year, and how are tax appeals and refunds treated?
• ✓If new costs appear, how is the baseline adjusted to make the comparison fair?
• ✓Is there a cap on increases in controllable expenses?
• ✓What are our rights to review the landlord’s records?
• ✓Does the base year reset in a renewal or expansion?

To compare offers, run the same expected cost path through each structure across the full term, then add it to the rent. A slightly higher rent with a better baseline can be the lower-cost deal. At Tenant Advisory Group we represent tenants and model these options side by side, including the effect of expected occupancy changes on a building still leasing up. Have your attorney review the definitions, and your CPA can help with the budget effect.