Tenant Reimbursements in Commercial Real Estate

In This Article

• Tenant Reimbursements and Property Expenses
• Which Expenses Are Tenant Reimbursements?
  • Pro-rata
  • Escalator Clause
• Appreciating Concepts and Tenant Reimbursement
  • Base Year
  • Base Rent
  • Capped Reimbursements
  • Gross vs. Net
  • Percent Rent
• FAQs
  • About the Author

For prospective landlords, tenant reimbursements can be a major point of consideration when evaluating rental properties. It’s important to understand which expenses apply and the extent that they need to be covered—as well as how much can come from tenant reimbursements. Although there is no universal policy for setting up such an arrangement, some common methods are often employed by property owners looking to maximize their return on investment while ensuring fair practices concerning rentals under their purview.

What are Tenant Reimbursements in Commercial Real Estate?

Tenant reimbursements in commercial real estate refer to the process by which landlords recover certain property-related expenses from their tenants. These expenses typically include operating costs, maintenance fees, property taxes, and insurance. Landlords may pass on these costs to tenants through reimbursements, ensuring that the financial burden of maintaining and operating the property is shared among all occupants.

What Are the Benefits of Tenant Reimbursements for Landlords?

1. Cost Recovery: Tenant reimbursements allow landlords to recover the costs associated with maintaining and operating commercial properties. This includes expenses such as property taxes, insurance, and common area maintenance.
2. Stable Income: By passing on certain costs to tenants, landlords can achieve a more predictable and stable income. This can be particularly beneficial in managing cash flow and budgeting for property-related expenditures.
3. Property Maintenance: Tenant reimbursements encourage tenants to participate in the upkeep of shared spaces, leading to better-maintained properties. This benefits both landlords and tenants by preserving the value of the property.
4. Competitive Lease Terms: Offering tenant reimbursements can make a property more attractive to potential tenants. It allows landlords to offer competitive lease terms while still covering the essential costs of property ownership.

What Are the Legal Requirements for Tenant Reimbursements?

1. Lease Agreements: Legal requirements for tenant reimbursements are typically outlined in the lease agreement. It’s crucial to clearly define which expenses are eligible for reimbursement, how they will be calculated, and the frequency of payments.
2. Transparency: Landlords must be transparent about the expenses being passed on to tenants. Clear communication and documentation are essential to avoid disputes and ensure compliance with legal requirements.
3. Compliance with Local Laws: Landlords need to be aware of and comply with local laws and regulations regarding tenant reimbursements. Some jurisdictions may have specific rules governing the types of expenses that can be passed on to tenants and the permissible methods of calculation.
4. Fair and Non-Discriminatory Practices: Landlords must apply reimbursement practices fairly and without discrimination. The allocation of expenses should be reasonable and justifiable, treating all tenants equally.
5. Notices and Disclosures: Some jurisdictions may require landlords to provide tenants with notices and disclosures regarding reimbursement charges. This ensures that tenants are informed about the additional costs they may incur.

Tenant Reimbursements and Property Expenses

To get a complete picture of the expenses of a particular property, one must read the income and expense sheet prepared for that property. This document details a property’s costs within the last few years and its future financial projections. It is available to interested investors so they can adequately evaluate the property. 

List of Common Expenses Applies to Commercial Properties

The following is a list of common expenses that apply to most commercial properties and a brief explanation.

• Utilities: These are the costs of the services required to operate a building. These include water, sewer, gas, electricity, phone, and internet.
• Repairs and maintenance: These are the costs of a property’s day-to-day repairs and upkeep.
• Management fee: The fee a company or individual charges to collect rent, oversee workers, and deal with any issues arising at the property. A buyer usually calculates the management fee as around 5% of the effective gross income. A cost of about 4% may be used for a larger property.
• Payroll: The labor cost of a super or maintenance worker on or off the premises—full or part-time.
• Insurance: This is the cost to insure the building—hazard insurance, liability insurance, or both.
• Real Estate Tax: This is a property tax owed to the government. They are levied locally and vary by taxing jurisdiction. The real estate tax base is the taxable (assessed) value of land and improvements.

Which Expenses Are Tenant Reimbursements?

Beyond the set amount paid for the rent, tenants usually pay a certain amount per month to cover the operating expenses of the building. For example, which expenses are tenant reimbursements? The amount will vary according to the type of property and the particular arrangement with the landlord. 

The landlord usually pays the entire water, sewer, and electricity costs in an apartment building. In some multifamily properties, tenants have individual meters and pay their own utilities. In this case, the landlord only pays for the common areas of the building (for example, hallways and outdoor lights). 

Reimbursement Methods for Commercial Real Estate

With office buildings and shopping centers, it is common to have tenants reimburse the landlord for their share of all the expenses. Each tenant keeps separate meters and pays for the utilities used by his space on the property. However, the general building expenses, such as taxes and insurance, cannot be so simply apportioned. At times a reasonable amount is agreed upon and set as the amount the tenant is responsible for paying regardless of any fluctuation of the cost for that expense. However, the expenses of taxes and insurance usually work with the following two methods:

Pro-rata

The simplest reimbursement method is to pay for all expenses, pro-rata or proportionately. Each tenant’s share is calculated as the percent of the building their space occupies. For example, if an insurance bill that a company reimburses totals $20,000 for the entire property, and the space they occupy is 15% of that property, their share would be $3,000 ($20,000 divided by 15%).

Escalator Clause

Using the escalator clause, a tenant will reimburse a landlord only for any expenses increase above a given base year. The base year is the year that all future calculations are based upon and is usually the year the lease begins, although it can vary from lease to lease. 

Thus, a full calendar year of expenses is considered the base year. Any expenses above that amount are the tenant’s responsibility, in proportion to the percentage of space the tenant occupies. This can be the arrangement for the real estate taxes or insurance expenses, or this arrangement can be used for all of the reimbursements of a building.For example, a tenant who occupies 15% of a shopping center agrees to pay the real estate taxes on an escalator scale. The base year taxes for the property are $185,000. The following year, the tax amount increased to $200,000. This tenant is thus liable to pay $2,250, which is 15% of the increase ($15,000 divided by 15%).

Appreciating Concepts and Tenant Reimbursement

Base Year

Before moving forward, allow me to describe base rent briefly. In a commercial lease context, base rent is the minimum rent due under a lease. Depending on the terms of the lease agreement, a lease with a base rent usually includes an escalation clause for taxes and operating expenses and sometimes a percentage rent clause.

For commercial leases, this rate is often quoted on a square foot per year basis, meaning that a 10,000-square-foot tenant paying a base rate of $20 per square foot will pay $200,000 a year in base rent. You may see this written out as $20 NNN + opex.

Base Rent

Considering base rents, it is essential to add one caveat to this calculation. Unfortunately, you can’t conclude that a building with an average rent of $18 per square foot in a market of $24 per square foot will automatically increase the gross income by $6 a foot when the lease renews. A new lease will carry lower reimbursements because the base years will be reset for the current year’s expense, which is probably higher than that of the original lease. As such, although the reimbursement income will decrease and the gross rent will increase, the ultimate net will not be as great as the $6 per foot increase anticipated.

Capped Reimbursements

At times, a lease stipulates a cap on reimbursements. For example, a tenant may stipulate that they will pay their pro-rata share of any increase above the base year but only up to 5% above the previous year’s expenses. This way, the tenant is protected from dramatic rises in costs from year to year.

Gross vs. Net

An arrangement in which the landlord is responsible for all of the expenses of the building and the tenant does not contribute towards any of the reimbursements is called a gross lease. The landlord pays the real property taxes, owner’s insurance, liability insurance, and maintenance. 

In a net lease, the tenant is responsible for some expenses. This classification is further divided into net, double net, or triple net, reflecting different tenant responsibility levels for the expenses. The best setup from the landlord’s point of view is the triple net lease (NNN), where the tenant pays all of the expenses associated with the property’s operation, from utilities to license fees. In an NNN setup, the only expenses that remain the landlord’s responsibility are those not directly related to the use of the building, such as income taxes and debt service (payments for the mortgage).

The details regarding the exact setup of reimbursements change from lease to lease and are the subject of negotiations between the tenant and landlord.

Percent Rent

Another expense, although not considered a tenant reimbursement that a tenant can pay his landlord, which fluctuates monthly, is “percent rent.” In a “percent rent” arrangement, the tenant pays the landlord, in addition to a fixed monthly amount, a percentage of all his profits above a specific dollar amount. The landlord is thus allowed to share in any profits a tenant brings in. This arrangement is most common in shopping malls.

The fixed portion of the monthly rent is called the base rent. The tenant must give this amount regardless of profit. After the tenant brings in an agreed-upon amount of revenue for the month, the landlord starts collecting a percentage. This point is called the “break point” or “break-even point.” The break point is estimated by the amount the tenant is guaranteed to cover all his expenses and walk away even. Anything the tenant makes above that amount is considered profit, of which the landlord takes a share.

In summary, tenant reimbursements in commercial leases can be complicated and require careful consideration of various factors. From ensuring the correct terminology is used in the lease to ensuring all expenses are addressed, these reimbursements make it essential to consult an experienced real estate professional. 
Fortunately, the experts at GPARENCY can help ensure that your property has the best protection by examining all aspects of a given fee or expense and negotiating reimbursement rates. If you have questions regarding tenant reimbursements or any other commercial real estate needs, contact GPARENCY today for accurate, reliable advice. We look forward to assisting you with any requests you may have.

FAQs:

1. How do capped reimbursements affect my bottom line as a landlord?
   • Capped reimbursements may not directly impact a landlord’s bottom line, as reimbursements are typically not a primary source of income for rental property owners. However, suppose you receive reimbursements from a government program or insurance company for providing subsidized housing. In that case, a cap on the maximum reimbursement amount may limit the rent you can charge.
     
     For example, if you participate in a housing assistance program that provides a fixed subsidy amount, a cap on the maximum subsidy amount could limit the rent you can charge for your property. This could reduce your overall rental income and affect your profit margins.
2. Which is a better route to take in a lease—pro-rata or an escalator clause?
   • Ultimately, the choice between a pro-rata or an escalator clause depends on the specific needs and priorities of the landlord and tenant, as well as the prevailing market conditions and legal requirements. Therefore, it is important to evaluate each approach’s pros and cons carefully and consult with legal and financial professionals before deciding.