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Commercial real estate leases come as two basic types – a net lease or a gross lease (and a few hybrids - check out the types of leases here). Net leases require that the tenant pay for certain operating expenses in addition to the set rental rate (referred to as base rent, minimum rent or net rent). Pass through provisions exist in commercial net real estate in order to simplify the process.
Pass through expenses in a commercial lease are the operating expenses that are required on top of the rent, and they “pass through” to the tenant from the landlord. The expenses that are including are property taxes, insurance, maintenance, repairs, and utilities (commonly referred to as CAM in retail leases, TMI in industrial leases and Additional Rent in office leases).
Pass through expenses can exist whether it is a single or multi-tenant building. Other additional expenses such as landscaping are often paid in proportion to their usage for multi-tenant spaces.
The pass-through lease often results in the tenant having more financial responsibility. With that responsibility, also comes more freedom and control. The tenant is able to control which operational costs are going to directly affect their business, which would therefore be more beneficial.
For example, if HVAC can be a pass through expense and if the tenant handles the maintenance costs directly, then the landlord is not adding a 15% management fee on top of that cost, which is often what happens.
This does come with the duty of having to pay those bills and arrange for the contractors and maintenance people, however.
In the case of the landlord, they are relieved of financial responsibility associated with maintenance and repair service expenses. This is beneficial for the landlord since they are able to include almost any operating expense that exists as the responsibility of the tenant.
Simple pass throughs are most common for single-tenant spaces. In this case, the expenses are billed to the one tenant. If it is a multi-tenant property, then the charge for the expenses is simply divided among the tenants according to the proportion of the space they are in charge of (called the pro-rata share).
The pass through can also exist such that the tenant is only required to pay a portion of the expenses, as opposed to all of it.
In this case, the amount that the landlord pays up until is known as the expense stop.
The remainder of what is left is passed onto the tenant.
The expense stop can be chosen to either be a specific amount or a base-year stop, where the landlord is required to pay whatever the amount is in the first year of the lease, and the tenant pays the increase during the following years.
The two components of operating expenses that often cannot be negotiated and are almost automatically passed onto the tenant are insurance and property tax.
They are considered to be uncontrollable and are therefore also not negotiated.
Expenses that can be negotiated are controllable, otherwise known as CAM (Common Area Maintenance) expenses. CAM expenses include things like management fees, building maintenance, utilities, administrative fees, waste disposal, lighting, parking lot maintenance, security guards, snow removal, etc.
As a tenant there are certain operating expenses that you must ensure are excluded.
The landlord cannot pass on any expenses associated with ownership.
This includes refinancing, marketing for the property, accountant fees, ownership tax returns, capital expenditures, debt service, tenant improvement allowances legal fees and broker commissions. The landlord should only be passing on expenses associated with maintenance and operation.