What Are Pass-Through Expenses in Commercial Real Estate?

In commercial real estate, a lease agreement is more than just the monthly rent. Landlords incur costs to operate and maintain a property, and pass-through expenses are the mechanism used to share these costs with the tenants who benefit from them. The purpose of this arrangement is to recover expenditures for property-wide services, ensuring the base rent represents the physical space while operational costs are handled separately.

Common Categories of Pass-Through Expenses

Property taxes represent one of the largest and most common pass-through expenses. These are taxes levied by local government entities on the real estate itself. Landlords pass this cost on to tenants because the value and tax burden of the property are influenced by its occupancy and commercial use.

Building insurance is another standard pass-through charge. This covers the landlord’s insurance policies for the property, which includes property insurance against perils like fire and flood, as well as general liability insurance for the common areas. This does not cover a tenant’s personal property or business liability, so tenants must carry their own separate insurance.

Common Area Maintenance, or CAM, is the most varied category of pass-through expenses. These are costs associated with the upkeep and management of areas shared by all tenants. Inclusions are:

• Landscaping
• Parking lot maintenance, such as sweeping and repairs
• Snow removal
• Security services
• Utilities, janitorial services, and supplies for common spaces like lobbies, hallways, and restrooms

Leases also specify exclusions from CAM charges, such as:

• Costs for marketing vacant spaces
• Brokerage commissions
• Salaries for personnel above the property manager level
• Expenses for which the landlord is reimbursed by insurance

CAM can also include administrative or property management fees, calculated as a percentage of total operating costs. While major capital expenditures that improve the property’s value are excluded, some leases allow for the amortization of capital improvements that reduce operating costs. For example, the cost of a new, more energy-efficient HVAC system might be amortized over its useful life, and the annual amortized amount could be included in CAM expenses.

Methods for Calculating Tenant Share

A tenant’s portion of pass-through expenses is their pro-rata share. This is determined by dividing the tenant’s rentable square footage by the total rentable square footage of the entire property. For instance, if a tenant leases 2,000 square feet in a 20,000-square-foot building, their pro-rata share is 10%. This percentage is then applied to the total passed-through operating expenses for the year.

The most common lease structure utilizing this calculation is the Triple Net (NNN) lease. In a NNN lease, the tenant is responsible for their pro-rata share of property taxes, building insurance, and common area maintenance. These charges are paid in addition to the base rent. This structure is prevalent in retail and freestanding commercial properties.

In contrast, other lease types modify how these expenses are handled. A Modified Gross lease includes some or all operating expenses in the base rent for the first year of the lease term. This initial year establishes what is known as a “base year” or an “expense stop.” In subsequent years, the tenant is only responsible for paying their pro-rata share of any increases in operating expenses above the amount established in that base year.

The Annual Reconciliation Process

Tenants do not pay the exact pass-through costs as they are incurred. Instead, landlords project an annual budget for property taxes, insurance, and CAM expenses at the beginning of the year. Based on this budget, they calculate an estimated monthly charge for each tenant, which is then paid along with their base rent throughout the year. This provides the landlord with consistent cash flow to cover operating costs.

After the fiscal year concludes, the annual reconciliation, or “true-up,” begins. The landlord will compile a detailed, itemized statement of all the actual operating expenses incurred for the property over the past year. This statement is provided to tenants within the first quarter after the fiscal year ends and details the real costs for taxes, insurance, and CAM.

The landlord compares the total actual expenses to the estimated payments collected from the tenant. If the tenant’s payments exceeded their share of actual costs, the landlord issues a credit, often applied to future rent. If actual costs were higher than estimates, the landlord sends an invoice for the balance, which is due within 30 to 60 days.

Key Lease Provisions to Review

When entering a commercial lease, review the clauses governing pass-through expenses. Pay attention to the section defining “Operating Expenses” or “CAM.” A well-drafted lease will provide a detailed list of what costs are included and excluded.

Identify any “cap” on annual expense increases. A cap limits how much certain operating expenses can rise annually, expressed as a percentage. For example, a 5% cumulative cap means the expenses cannot increase by more than 5% over the previous year’s total. These caps apply to “controllable” expenses the landlord can manage, like landscaping, but not to “uncontrollable” expenses like property taxes and insurance.

Ensure the lease contains an audit right clause. This provision grants the tenant the right to inspect the landlord’s expense records. The clause specifies a timeframe for the tenant to give notice, ranging from 30 to 180 days after receiving the annual reconciliation statement. The lease often stipulates that if an audit reveals an overcharge of 3% to 5%, the landlord is responsible for the audit’s cost.