In commercial real estate, many leases include a provision called an expense stop, ensuring that the landlord pays for operating expenses up to a certain point — but not past that point.
An expense stop is the maximum amount a landlord will spend on operating expenses. Any amount above the expensive stop becomes the tenant’s responsibility. 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. These limits are usually found in gross leases like office leases, where the landlord is responsible for all expenses. When an expense stop is in place, there is a limit on landlord liability, Hogan explained.
According to Dr. David Phelps, Founder and CEO at Freedom Founders, additional operating expenses may include property taxes, insurance and common area maintenance, utilities, etc. 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.” Essentially, the expense stop clause amount and terms are agreed upon by both the tenant and the landlord in the lease agreement.
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. The first year, or base year, establishes what amount of operating expenses the landlord is responsible for in future years. In the base year, the amount paid by the landlord establishes the stop’s limit, Hogan explained. In future years, the tenant pays any expenses over the amount paid in the base year.
Whether or not an expense stop is beneficial to both the landlord and the tenant can vary, depending on the specific situation. However, there are a number of potential pros and cons.
For the landlord, one benefit of an expense stop is the ability to control costs, even during inflation and 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 can be beneficial because it reduces their required contribution to the landlord’s operating expenses. Without an expense stop, they may be paying a larger chunk of operating expenses, depending on the terms of their lease.
One downside of an expense stop for landlords is that it may prevent them from attracting tenants. “Some tenants prefer a ‘gross lease’ where the rent is set and there are no operating costs passed on to the tenant,” Phelps said. This dynamic leads to the downside of expense stops for tenants. 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.
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 $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.
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.
