How to Prevent Costly Leakage

Last updated Nov 17, 2023
U-Rite University
Financial Modeling
Excel Template

In the world of commercial real estate, leakage refers to when the operating expenses of a property exceeds the revenue collected from tenant recoveries. Leakage can significantly impact the profitability and success of commercial real estate ventures. In this article, we will explore the concept of commercial real estate leakage, its implications, and strategies to identify and prevent it. By understanding and effectively mitigating leakage, real estate professionals can maximize returns and optimize their investment outcomes.

What Causes Leakage?

To illustrate leakage, let’s use a basic example. Imagine you’re a property owner of a 50,000 SF building and you have one tenant “Tenant A” occupying 25,000 SF. The remaining 25,000 SF is vacant until “Tenant B” moves in on Month 13 of the analysis. Both tenants are paying $12 / SF / Year, and NNN (triple net) recoveries, so they pay their pro-rata share of the operating expenses.

Here we assume our operating expenses are $2.40 / SF / year and a variable percent of 100%. A variable percent of 100% means that the total is 100% dependent on occupancy, (i.e. if occupancy is 0% then operating expenses are $0).

Year 1 – (before Tenant B moves in):

\( $2.40/SF \times 50,000 \, SF \times 50\% = $60,000 \)

Year 2+ – (after Tenant B moves in):

\( $2.40/SF \times 50,000 \, SF \times 100\% = $120,000 \)

Tenant A’s pro-rata share for recoveries in year 1:

\( $60,000 \times \frac{25,000 \, SF}{50,000 \, SF} = $30,000 \)

If we compare our Total Operating Expenses to our Expense Recoveries, we can see that we are spending $60,000 on Operating Expenses but only recovering $30,000 from Tenant A. This equalizes when Tenant B moves in and the building is 100% occupied.

Cash flow with leakage in year 1.

This means that our building is leaking $30,000 in Year 1. This is unfair to you (the landlord) because since Tenant A is the only tenant using utilities, they should pay for closer to 100% of the operating expenses for year 1.

What is Recovery Gross-Up?

This is where we apply the concept of “Gross-Up”. A gross-up applies a minimum assumed occupancy for the variable portion of tenant recoveries to prevent this from happening.

Here with a 95% gross-up applied to Tenant A:

\( $60,000 \times MAX(\frac{25,000 \, SF}{50,000 \, SF},\,95\%) = $57,000 \)

Cash flow with year 1 leakage minimized using gross-up.

With this applied gross-up, the recoveries remain the same for years 2+, but we’ve reduced our leakage in Year 1 from $30,000 to only $3,000.


This is a basic example that doesn’t consider the many nuances of more complex deals (like common spaces and larger rent rolls with more detailed recovery structures), but it demonstrates a common flaw in many simplistic financial models. Not accounting for leakage in financial models can greatly skew your returns and you could be leaving money on the table.

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