What Is an Expense Stop in Commercial Real Estate?

By Published On: June 15, 20225.4 min read

In commercial real estate, many leases include a provision called an expense stop, whereby the landlord pays for operating expenses up to a certain point — but not past that point. Expense stops may also be referred to as a “base stop” or, more generally, may fall within a “modified gross” lease structure. The payments of operating expenses by tenants are typically referred to as “expense reimbursements.”

What Is an Expense Stop?

An expense stop is the maximum amount a landlord will spend on operating expenses. This may be specific to one expense or a grouping of expenses. Any amount above the expense stop becomes the tenant’s responsibility. The tenant’s responsibility is usually apportioned by their pro-rate share, or their percentage of square footage at the property. The denominator when calculating the pro-rata share is typically the overall property size but may vary. For example, the calculation may exclude retail or storage space for reimbursements of an expense related to office space only (such as cleaning).

Expense stops are usually determined in the lease agreement, with a written “limit on the amount of operating expenses that a landlord is required to pay per the lease,” said Reid Hogan, a Commercial Real Estate Advisor at LandCashin. When an expense stop is in place, there is a limit on landlord liability, Hogan explained. This is atypical of residential leases but is commonly found in commercial properties.

According to Dr. David Phelps, Founder and CEO at Freedom Founders, operating expenses may include property taxes, insurance and common area maintenance, utilities, etc. Leases may specify other tenant responsibilities as well. Phelps also noted that sometimes “tenants can assume exposure to all property-related risks, even casualty or condemnation, in which the tenant would be responsible for rebuilding a damaged property.” This clause would be separate from reimbursement language.

Essentially, the expense stop clause amount and terms are agreed upon by both the tenant and the landlord and explained in the lease agreement.

Expense Stop vs Base Year: What’s the Difference?

A base year refers to a type of expense stop in which the landlord pays for all operating expenses in the first year. After that first year, Phelps explained, the tenant is responsible for all operating expenses over and above the first year’s established base year expenses. This is the most common form of an expense stop.

The first year, or base year, establishes what amount of operating expenses the landlord is responsible for. Various expenses may be included or excluded; for example, in the New York City market, retail tenants may only reimburse for real estate taxes over a base year, while office tenants’ reimbursements will include both taxes and other operating expenses. In future years, the tenant pays any expenses over the amount paid in the base year. The landlord should still consider that upon lease expiration, the base year will often re-set in the event of a lease renewal.

An experienced leasing broker representing a tenant will investigate whether the projected expenses for the coming year are considered “stabilized” before agreeing to set the base year in the lease. For example, a newly constructed or renovated property may see significant increases in real estate taxes in the initial years of a new lease. The tenant may be left with significant exposure to reimburse these substantial increases. A sophisticated tenant representative will instead elect to set the base year as a fixed amount, or agree to use a future year for the base year.

Pros and Cons of Expense Stops

Whether or not an expense stop is beneficial to the landlord or the tenant may vary, depending on the specific situation.

Benefits

For the landlord, one benefit of an expense stop is the ability to control their exposure to rising expenses, especially given the current climate with regards to inflation or increases in property taxes and insurance premiums, Hogan said.

Landlords will also have a clear idea of their maximum operating expenses each year, allowing them to budget for that limit.

For tenants, an expense stop may be favorable to a net reimbursement structure. Without an expense stop, they may be paying a larger amount of operating expenses, depending on the terms of their lease. A tenant may also negotiate a specific cap on the annual increase of their reimbursement amount, in an effort to control their exposure.

Drawbacks

One downside of an expense stop for landlords is that it may prevent them from attracting tenants, especially smaller or less sophisticated users.

“Some tenants prefer a ‘gross lease’ where the rent is set and there are no operating costs passed on to the tenant,” Phelps said.

With a gross lease, the tenant’s payment is fixed throughout the term, and all expenses are the landlord’s responsibility.

With an expense stop, tenants have no control over the payment of operating expenses. An increase in property taxes or property management fees could make their rental costs increase dramatically from year to year. Further, the tenant is not the party operating the building, so the lease may call for specific requirements with regards to controlling the expenses. For example, the lease may specify that the landlord is required to challenge the tax assessment each year, since any increases would end up as the tenant’s responsibility. Another example would be setting a cap on the management fees that go into the calculation pool, since the landlord could elect to pay themselves an increased management fee and pass the increases through to the tenant.

Expense Stop Example

An example of an expense stop, Phelps illustrated, is when a tenant signs a lease for 5,000 square feet of commercial space at $20 per square foot (PSF), with the landlord covering all expenses up to $5 PSF, or $25,000.

In this scenario, if the actual expenses turn out to be $6 PSF, or $30,000, and the landlord has an expense stop at the pre-negotiated $25,000, the tenant is responsible for the additional $5,000 in operating expenses above the $25,000.

Before Negotiating an Expense Stop, Talk to an Expert

Both landlords and tenants need to weigh the pros and cons of an expense stop for their specific situation. Many times, what works for one commercial property may not work as well for another. Phelps recommends that tenants “consult with an experienced leasing agent or manager to assist with evaluating the costs and potential liabilities.” It’s important for tenants to do their due diligence before forming any type of lease agreement.

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