The treatment of expenses is an important part of any lease, so it helps to understand the underlying dynamics and terminology
Base Rent in a NNN lease never includes expenses.Tenants pay them, in addition to Base Rent, from the outset.
Expense risk keeps Landlords awake at night. If income (rent) is fixed and expenses increase,
profits decline. So, Landlords seek to shift expense risk to Tenants. One way is
a NNN Lease, where Tenants pay all expenses and bear all the risk. This works best
where a Tenant has actual control over expenses, as in a single-tenant building
or Flex Space with no Common Area. But in a multi-tenant property, where Tenants don’t
really control expenses, a NNN Lease does not make as much sense.
In a Gross Lease with Pass-Throughs, Base Rent in year 1 includes expenses; future years' increases are billed seperately.
Multi-tenant Landlords have developed other ways to shift some or all expense risk
to their Tenants. Some leases (such as Gross + Electric or Modified Gross) shift
only certain expense categories to the Tenant. Another approach
is to pass through only the increase in expenses above their level in the year the
lease was signed (the Base Year). This is called a Pass Through Escalation.
One complaint is that a straight Pass Through is too good at shifting risk, removing Landlord’s
incentive to economize. Tenants can mitigate this with an Expense Stop, (
Landlord pays the first part of an increase up to a certain level), or with an Expense Cap
(Tenant pays the first part of an increase, up to a certain level). Finally, some leases feature a
simple CPI Escalation, which uses an objective measure of inflation to adjust the
Base Rent, and eliminating the need to audit your Landlord's expenses.
A
Word about BILLING ESCALATIONS:
Landlords bill escalations by estimating what the expenses will be in an upcoming
year, and charging 1/12th of that estimate each month. After year-end, they reconcile
actual expenses with the estimate and charge (or refund) a true-up amount.
So what’s the upshot of all this for a Tenant? Generally it is best to i) limit
or cap your exposure to expense increases, ii) make sure there is an incentive for
Landlord to spend wisely, and iii) use objective, easily definable measures to determine
escalations.