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The term "pro rata" is used in numerous industries– everything from finance and insurance to legal and advertising. In commercial real estate, "pro rata share" refers to allocating expenses among multiple tenants based on the space they lease in a building.
Understanding pro rata share is essential as a commercial real estate investor, as it is an important concept in determining how to equitably allocate expenses to tenants. Additionally, pro rata share is often vigorously debated during lease negotiations.
What exactly is pro rata share, and how is it calculated? What expenses are typically passed along to tenants, and which are typically absorbed by commercial owners?
In this discussion, we'll look at the main components of pro rata share and how they logically connect to commercial real estate.
"Pro Rata" means "in proportion" or "proportional." Within commercial real estate, it refers to the method of calculating what share of a building's expenses should be paid by each tenant. The calculation used to determine the precise proportion of expenses a tenant pays should be specifically defined in the tenant lease agreement.
Usually, pro rata share is expressed as a percentage. Terms such as "pro rata share," "pro rata," and "PRS" are commonly used in commercial real estate interchangeably to discuss how these expenses are divided and managed.
In short, a tenant divides its rentable square footage by the total rentable square footage of a property. In some cases, the pro rata share is a stated percentage appearing in the lease.
Leases often dictate how space is measured. In some cases, specific standards are used to measure the space that differs from more standardized measurement methods, such as the Building Owners and Managers Association (BOMA) standard. This is important because significantly different outcomes can result when utilizing measurement methods that differ from normal architectural measurements. If anyone is uncertain how to properly measure the space as stipulated in the lease, it is best they call upon a pro experienced in using these measurement methods.
If a building owner rents out space to a new tenant who commences a lease after construction, it is vital to measure the space to verify the rentable space and the pro rata share of expenses. Rather than relying on construction drawings or blueprints to determine the rentable space, one can use the measuring method outlined in the lease to create an accurate square footage measurement.
It is also important to verify the property's total area if this is in doubt. Many resources can be used to find this information and assess whether existing pro rata share numbers are reasonable. These resources include tax assessor records, online listings, and property marketing material.
A lease should describe which operating expenses are included in the amount tenants are charged to cover the building's expenses. It is common for leases to start with a broad definition of the operating expenses included while diving deeper to explore specific items and whether or not the tenant is responsible for covering the cost.
Dealing with operating expenses for a commercial property can sometimes also include adjustments so that the tenant is paying the actual pro rata share of expenses based on the costs incurred by the landlord.
One frequently used method for this type of adjustment is a “gross-up adjustment.” With this method, the actual amount of operating expenses is increased to reflect the total cost of expenses if the building were fully occupied. When done correctly, this can be a practical way for landlords/owners to recoup their expenses from the tenants leasing the property when vacancy rises above a certain amount stated in the lease.
Both the variable expenses of the property as well as the property's occupancy are taken into consideration with this type of adjustment. It's worth noting that gross-up adjustments are one of the commonly debated items when lease audits occur. It's essential to have a complete and comprehensive understanding of leasing issues, property accounting, building operations, and industry standard practices to utilize this method successfully.
When discussing operating costs and the pro rata share of expenses allocated to a tenant, it is important to understand CAM charges. Common Area Maintenance (or CAM) charges refer to the cost of maintaining a property’s commonly used spaces.
CAM charges are passed onto tenants by landlords. Any expense related to managing and maintaining the building can theoretically be included in CAM charges—there is no set universal standard for what is included in these charges. Markets, locations, and even individual landlords can vary in their practices when it comes to the application of CAM charges.
Owners benefit by adding CAM charges because it helps protect them from potential increases in the cost of property maintenance and reimburses them for some of the costs of managing the property.
From the tenant perspectives, CAM charges can understandably be a source of stress. Knowledgeable tenants are aware of the potential to have higher-than-expected expenses when costs fluctuate. On the other hand, tenants can benefit from CAM charges because it frees them from the predicament of having a landlord who is reluctant to pay for repairs and maintenance. This means that tenants are more likely to enjoy a well-maintained, clean, and functional space for their business.
Lease specifics should define which costs are included in CAM charges.
Some common expenses include:
CAM charges are most generally calculated by determining each tenant's pro rata share of square footage in the building. The amount of space a tenant occupies directly relates to the percentage of common area maintenance charges they are responsible for.
The type of lease that a tenant signs with an owner will determine whether CAM fees are paid by a tenant. While there can be some differences in the following terms based on the market, here is a quick breakdown of common lease types and how CAM charges are dealt with for each of them.
Tenants assume almost all the responsibility for operating expenses in triple net leases (NNN leases). They pay their pro rata share of property insurance, property taxes, and common area maintenance (CAM). The landlord will typically only have to foot the bill for capital expenditures on his/her own.
The results of lease negotiations can modify tenant responsibilities in a triple-net lease. For example, a "stop" could be negotiated where tenants are only responsible for repairs for certain systems up to a certain dollar amount annually.
Triple net leases are common for commercial rental properties such as strip malls, shopping centers, restaurants, and single-tenant properties.
Tenants pay their pro rata share of property insurance and property taxes in net net leases (NN leases). When it comes to common area maintenance, the building owner is responsible for the costs.
Though this lease structure is not as common as triple net leases, it can be beneficial to both owners and tenants in some circumstances. It can help owners attract tenants because it minimizes the risk resulting from fluctuating operating costs while still allowing owners to charge a slightly higher base rent.
Tenants that sign a net lease for a commercial space only have to pay their pro rata share of the property taxes. The owner is left responsible for common area maintenance (CAM) expenses and property insurance.
This type of lease is much less common than triple net leases.
Very common for office buildings, landlords cover all of the costs for insurance, property taxes, and common area maintenance.
In some gross leases, the owner will even cover the tenant's utilities and janitorial costs.
In most cases, calculating the pro rata share a tenant is responsible for is quite straightforward.
The first thing one needs to do is determine the total square footage of the space the tenant is leasing. The lease agreement will typically note how many square feet are being leased by a particular tenant.
The next step is determining the total amount of square footage of the building used as a part of the pro rata share calculation. This space is also known as the defined area.
The defined area is sometimes described in each tenant's lease agreement. However, if the lease does not include this information, there are two methods that can be used to determine defined area:
It is typically more advantageous for tenants to use GLA rather than GLOA. This is because the building's expenses are shared between current tenants for all the leasable space, regardless of whether some of that space is being leased or not. The owner takes care of the expenses for vacant space, and the tenant, therefore, is paying a smaller share of the total cost.
Using GLOA is more advantageous to the building owner. When only including leased and occupied space in the definition of the building's defined area, each tenant effectively covers more expenses of the property.
Finally, take the square footage of the leased space and divide it by the defined area. This yields the percentage of space a particular tenant occupies. Then multiply the percentage by 100 to find the pro rata share of expenses and space in the building for each tenant.
If a tenant increases or decreases the amount of space they lease, it can change the pro rata share of expenses for which they are responsible. Each tenant's pro rata share can also be impacted by a change in the GLA or GLOA of the building. Information about how such changes are dealt with should be included in tenant leases.
Accuracy and precision are critical when calculating pro rata share. Tenants can be overpaying or underpaying significantly over time, even with the smallest error in calculation. Mistakes of this nature that are left unchecked can create a real headache down the road.
The tenant's cash flow can be significantly impacted by overpaying their share of expenses, which in turn impacts tenant satisfaction and retention. Conversely, underpaying can put all stakeholders in a difficult situation where the landlord could require the tenant to repay what is owed once the mistake is discovered.
It is essential to carefully define pro rata share, including calculations, when creating lease agreements. If a new landlord is inheriting existing tenants, it’s important they check leases carefully for any language affecting how the pro rata share is calculated. Ensuring calculations are carried out correctly the first time helps to avoid financial problems for tenants and landlords while reducing the potential for tension in the landlord-tenant relationship.
Whether your tenants are paying their pro rata share of property taxes and other expenses or you're using a gross lease and footing the bill yourself, increasing efficiency and reducing risk when it comes to managing your property taxes and other expenses is essential.
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