Expense Reimbursements

Definition of Expense Reimbursements

In the context of commercial mortgages, expense reimbursements—often referred to as "recoveries" or "pass-throughs"—are payments made by tenants to a property owner to cover specific operating costs associated with the property. These payments are in addition to the base rent and are intended to offset the landlord's out-of-pocket expenses for maintaining and operating the asset. For a lender, these reimbursements are a vital component of the property's total income stream.

Detailed Description

Expense reimbursements play a critical role in determining a property’s Net Operating Income (NOI), which is the primary metric lenders use to calculate loan sizing and the Debt Service Coverage Ratio (DSCR). By shifting the burden of rising costs from the landlord to the tenant, reimbursements provide a hedge against inflation and unexpected increases in taxes or utility rates.

The nature and calculation of these reimbursements are dictated by the specific lease structures in place:

• Triple Net (NNN) Leases: These are the most favorable for landlords and lenders. The tenant pays a pro-rata share of nearly all operating expenses, including property taxes, insurance, and Common Area Maintenance (CAM).
• Modified Gross Leases: In these agreements, the landlord and tenant share the expenses. Often, these include a "Base Year" provision where the landlord pays expenses up to the amount incurred in the first year of the lease, and the tenant reimburses any increases beyond that amount in subsequent years.
• Full Service/Gross Leases: The landlord pays all operating expenses out of the base rent. While there are no reimbursements, lenders will carefully analyze these to ensure the rent is high enough to cover the "leakage" of rising costs.

When underwriting a commercial mortgage, lenders focus on several key aspects of expense reimbursements:

• Common Area Maintenance (CAM): This includes costs for landscaping, snow removal, security, repairs, and maintenance of shared areas. Lenders verify that these costs are truly recoverable based on the lease terms.
• Gross-Up Provisions: If a building is partially vacant, lenders may "gross up" variable expenses to what they would be at 95% or 100% occupancy. This allows the landlord to recover a higher percentage of costs from existing tenants, provided the leases allow for such adjustments.
• Expense Caps: Lenders look for "caps" in leases that limit how much a tenant's reimbursement can increase annually (e.g., a 5% cap on CAM increases). These caps can create a gap between what the landlord spends and what they can recover.
• Slippage: This is the difference between the total operating expenses and the total reimbursements collected. High slippage reduces the NOI and can result in a lower maximum loan amount.

In summary, expense reimbursements represent a mechanism to stabilize cash flow. A property with high recovery rates is generally considered lower risk by commercial mortgage lenders, as the landlord's profit margin is protected from fluctuations in property taxes, insurance premiums, and maintenance costs.