What is an Expense Stop in Commercial Real Estate?
In a full service gross lease, the tenant pays a base rental rate and the landlord is typically responsible for paying any additional expenses (such as CAM fees). The exception is those above a specific amount, called an expense stop. Any expenses that exceed the expense stop then become the responsibility of the tenant. In essence, the expense stop is the most a landlord will pay for expenses in any given year.
How Expenses Stops Actually Work
In many cases, expense stops are set a certain amount of operating expenses per square foot. For example, if the expense stop for an office property is set at $5/sq. ft., and operating expenses per sq. ft. are $7/sq. ft., a tenant would be responsible for paying the difference of $2/sq. ft (on their share of the property).
For instance, in the example above, if the office building had 15,000 sq. ft. and 3 tenants, one using 10,000 sq. ft., and the other two using 2,500 sq. ft., the tenants are responsible for paying for anything more than $75,000 a year in operating expenses ($5/sq. ft. * 15,000 sq. ft.).
If operating expenses that year reach $105,000 ($7/sq. ft. * 15,000 sq. ft.), the tenants are responsible for paying the $30,000 difference. The tenant occupying 10,000 sq. ft. pays $20,000, while the other two tenants occupying 2,500 sq. ft. pay $5,000 each.
Base Year Stops Also Help Landlords Limit Their Risk Exposure
In other situations, expense stops are set at a base year stop-- the actual operating expenses in the first year of the lease. In essence, the tenant doesn’t pay any additional operating expenses in the first year, but if expenses rise beyond that amount in subsequent years, they will be responsible for paying. By doing this, a building owner/developer ensures that their operational expenditures (OpEx), do not increase past the first year of leasing, allowing them to cut costs and improve the project's financial stability.
Sometimes in their lease agreement, a tenant requests an annual audit of their landlord’s operating expenses. They do this to ensure that they're not being taken advantage of. This is typically more common with larger tenants who have more negotiating power.