Prorata Expense Reimbursement

Definition of Prorata Expense Reimbursement

In the context of commercial mortgages and real estate, Prorata Expense Reimbursement is a lease provision that requires a tenant to pay their proportionate share of a building's operating expenses. This "pro-rata" share is typically calculated based on the percentage of the total rentable area that the tenant occupies. From the perspective of a commercial mortgage lender, these reimbursements are a critical component of a property’s Gross Income, as they offset the costs of maintaining the asset and directly impact the Net Operating Income (NOI).

How Prorata Shares are Calculated

The calculation for a tenant’s prorata share is straightforward but essential for accurate financial modeling during the mortgage underwriting process. It is generally expressed as a percentage using the following formula:

• (Tenant’s Square Footage / Total Building Square Footage) x 100 = Prorata Share %

For example, if a tenant occupies 2,500 square feet in a 10,000 square foot shopping center, their prorata share is 25%. Consequently, they would be responsible for 25% of the total reimbursable operating expenses incurred by the landlord.

Common Reimbursable Expenses

Lenders scrutinize the "expense recovery" section of a rent roll to see which costs are being passed through to tenants. Common expenses included in prorata reimbursements are:

• Real Estate Taxes: Property taxes levied by local municipalities.
• Property Insurance: Premiums paid to protect the physical structure and provide liability coverage.
• Common Area Maintenance (CAM): Costs for cleaning, landscaping, snow removal, parking lot repairs, and security.
• Utilities: Shared water, electricity, or gas services not individually metered for specific units.

Importance in Commercial Mortgage Underwriting

Prorata expense reimbursements are vital to the stability of a commercial mortgage for several reasons:

1. Inflation Protection: Because the tenant pays for increases in operating costs, the landlord’s Net Operating Income remains stable even if taxes or utility rates rise. This reduces the risk of the borrower defaulting on mortgage payments due to rising overhead.

2. Debt Service Coverage Ratio (DSCR): Lenders use the total income, including reimbursements, to calculate the DSCR. Higher reimbursement rates usually lead to a stronger DSCR, which can result in more favorable loan terms or higher loan amounts.

3. Valuation: Commercial properties are valued based on the income they produce. A property where tenants pay 100% of their prorata expenses (often seen in Triple Net or NNN leases) is generally viewed as lower risk and more valuable than a property where the landlord must absorb all costs (a Full Service Gross lease).

4. Expense Stops: In some mortgage scenarios, particularly with office buildings, lenders look for "Expense Stops." This is a variation where the landlord pays expenses up to a certain "base year" amount, and the tenant pays their prorata share of any increases above that amount. This protects the landlord's profit margin against future cost spikes.

Key Terms to Consider

When reviewing a loan application, lenders will look for specific clauses that might limit prorata reimbursements, such as Expense Caps (which limit how much a tenant's reimbursement can increase annually) or Gross-up Clauses (which allow the landlord to estimate expenses as if the building were fully occupied to ensure fair distribution of costs).