The Modified Gross Lease is the most favored form of lease for multi-tenant office space, primarily because it allocates financial risk between landlord and tenant in a way that reflects the respective control of the parties. However, if not drafted properly, a modified gross lease can cause a tenant to pay significantly more than understood by the parties when the deal was negotiated.
In most modified gross leases, the rent includes the costs of providing all of the normal building services, and the tenant is required to pay the landlord for its share of increases in the costs of such services over time. Increases are measured by comparing each year’s costs to those that were present in the year in which the lease was signed, or the “Base Year.” The business logic behind this clause is that it serves as a mechanism to protect the landlord from increases in costs due to inflation and other unanticipated events as the lease matures.
Because the Base Year is used each year to measure cost increases, it is imperative (from a tenant perspective) that the Base Year be reflective of what it normally costs to run the building. If it does omit anything, the Base Year costs will be understated, and the tenant’s increases will be overstated for each year of the lease.
Take these Precautions
There are precautions that must be taken in drafting a Base Year lease to ensure that this goal is preserved. The lease should provide that the base year be subject to adjustments (“gross-ups”) in order to compensate for any atypical costs that do not appear in the base year. Some of these are as follows:
a. Occupancy — Base year expenses should reflect the expenses that would have been incurred had the building been fully occupied at normal cost levels. Variable expenses, which are generally subject to gross-up include utilities, cleaning and management fees.
b. Warranties — In a newly constructed building, many of the building systems are under warranty. Consequently, the cost of maintaining such equipment during the warranty period is lower than during normal maintenance periods. Thus, the lease should provide that base year expenses should be adjusted to reflect normal maintenance costs in the absence of any warranties.
c. New Services — In the event the landlord wishes to add a new service to the building, the cost of such service the first year it appears should be added to the Base so that the operating expense escalations do not include the entire cost of such service. This is especially true if the tenant thinks it is getting the new service as part of the rent. In the absence of adding such service to the Base, the cost should be excluded from the escalation unless the tenant consents to adding the service at its expense.
d. Real Estate Taxes — The lease should provide that the base year for real estate taxes be the first year after the lease commencement in which the building has been assessed as fully completed and operational.
Conclusion
Note that providing for a gross-up of expenses where the building is not fully occupied or completed is not sufficient. Under this definition, the landlord might not be obligated (at least not pursuant to a literal reading of the lease) to adjust the base for free rent periods, where the space is occupied, but the rent stream is artificially deflated.