Avoid Pitfalls of CAM Caps During Operating Expense Negotiations

Operating expenses for an office building or retail property have the potential to make or break an owner’s or tenant’s budget. So it’s not surprising that they’re also a major point during lease negotiations. Your goal should be to pass through in the lease as many operating expenses as you can to the tenant. However, a savvy tenant will try to narrow your list of proposed charges. Depending upon the leverage and bargaining power of the tenant—which is much stronger for anchor tenants crucial to your shopping center or a tenant with office building name privileges—you might have to budge on some items. But you should start out with as broad a list as you can. Here are the operating expense items to fight for, and how you can include them in your lease provisions.

Understand the Big Picture for Pass-Throughs

The operating expenses that owners and tenants are generally concerned with fall into four categories: (1) common area maintenance (CAM); (2) taxes; (3) insurance; and (4) utilities. However, be aware that insurance and taxes can be treated differently: They can be included in CAM or classified as separate charges. And it’s common for insurance to be included, but taxes to be addressed separately. Likewise, utilities can be split, with all or some items, like gas and electricity, being paid directly while water is paid as a pro rata share.  

“In terms of common area facilities, a typical landlord will use a strong, general statement, such as ‘Tenant agrees to pay its pro rata share of common facility charges,’ followed by a defined list of those charges, and the specification that this will include all costs of operating and repairing common facilities in the building or center,” says Denver attorney Neil Oberfeld. He also notes that often the language will say “including without limitation” followed by specifics.

Drafting provisions with a strong statement that the tenant will pay all costs and expenses for common facilities in the building and property with additional details is a good start. But Oberfeld points out that while that general statement in some owners’ leases uses the terms “maintaining and repairing,” he prefers to say “operating, repairing, maintaining, upkeep, and replacing,” because this wording casts a wide net to cover a range of costs. So owners should try not to limit themselves with “repair” and “maintenance.”

It’s key to include “operating,” and ideally owners could negotiate “replacing;” however, that word is controversial. It’s also important for an owner, though. Tenants are reticent to agree to pay for replacing expensive equipment, like HVAC units and other items that wear out over time. That’s when the struggle regarding capital expenditures comes into play during negotiations. “The big issue when negotiating CAM provisions is the concept of capital expenditures,”Oberfeld says. He points out that a tenant will want to delete the word “replacing” and include in the CAM provisions an exclusion for capital expenditures. So be prepared for pushback from the tenant when it comes to this item.

Carefully Spell Out Details

In order to get a broad operating expense provision, you’ll have to include specific areas. It’s common for owners to ask for tenants to cover the cost of:

• Landscaping;
• Janitorial services (keep in mind that these services will vary according to your type of property, that is, whether interior window washing is needed—yes in a high-rise office building and but not in a single story property—and the type of replacement items that are necessary, such as which lightbulbs must be used);
• Repaving parking surfaces;
• Replacing HVAC systems (a big expense to fight for);
• Replacing the roof (you should ask for repairs and replacement to be passed through to the tenant, but be prepared to settle for just repairs);
• Association dues or assessments; and
• Marketing costs.

Practical Pointer: In addition to a struggle over HVAC and the roof, be prepared to address the tenant’s concerns about paying for janitorial services for “zones” in the property, like a food court, that aren’t close to or don’t benefit the tenant. Many tenants try to exclude promotional costs for current tenants or costs for tenant-centered events like holiday parties. Oberfeld says that these are fair requests to be passed through to tenants in CAM, but don’t try to include promotional costs for attracting new tenants—they aren’t fair game for inclusion in CAM.

Capital Expenditures: A Point of Contention

The issue of who will pay for capital expenditures is hotly contested in most negotiations, but remember that you almost always should be able to pass through capital expenditures to comply with changes in the law or new laws. Also, insist on any capital expenditure that is a cost-saving measure for tenants—like installing new ballasts for light fixtures that would save on electricity costs—and would ultimately reduce overall CAM expenditures.

“Expenditures for cost savings are generally acceptable to pass through,” says Oberfeld, “but tenants will also want capital expenditures like cost savings alterations or a new HVAC system to be amortized over its useful life.” So if the item will last 20 years, a tenant that is in the last year of its lease will want to pay one twentieth of the cost. “A large capital expenditure like resurfacing a parking lot or replacing an HVAC system is a hard pill to swallow for a tenant at its lease’s end,” Oberfeld notes. He notes that it could also be a windfall for the owner.

However, Oberfeld points out that during CAM exclusions negotiations, most of the typically 20 to 30 items listed in the landlord's detailed CAM definition will be fine with the tenant. But zingers that you’ve included (like purchasing art for the building or getting reimbursed for promotional events) are a sure bet to be deleted.

Oberfeld says that the overall feeling during negotiations is that tenants want to limit their responsibility to pay for capital expenditures or expensive items at their lease’s end, and they don’t want to pay for services such as redecorating the building’s lobby or janitorial for remote zones, especially where they will not even end up using them. At the end of the day, tenants’ demands like these may be reasonable.

CAM Cap Choice Is Crucial

Often, tenants will negotiate a cap on CAM costs limiting the percentage of the operating expenses that can be passed through. CAM caps can be troublesome for an owner, though, because a cap forces the owner to take on the risk of incurring expenses. It also defeats the purpose of triple-net (NNN) leasing, by which the owner collects rent as pure profit because the tenant pays for operating expenses of the property. If the owner under a NNN lease must pay for operating expenses that exceed the tenant’s cap, it erodes that profit.

However, high-quality tenants, like a national bank as opposed to a small local travel agency, are known to insist on passing that risk to the owner.

CAM cap negotiations ultimately lead to an agreement as to whether the cap will be “cumulative” or “non-cumulative.”

Cumulative CAM cap. The cumulative nature of this type of cap allows the owner to recover any unused increases from prior years. For example, if the owner and tenant agree to a 5 percent cumulative cap, and CAM expenses increase by 2 percent in the first year of the lease, then the tenant would pay the 2 percent increase, leaving the 3 percent unused. If CAM expenses increase by 10 percent in the second year of the lease, then the tenant would pay an 8 percent increase, despite the cap being set at 5 percent. That’s because, essentially, in addition to the 5 percent cap, the owner can recover the 3 percent increase that went unused in the first year.

Non-cumulative CAM cap. A non-cumulative CAM cap doesn’t allow the owner to recover any unused increases from prior years. If the owner and tenant in the example above agree to a 5 percent non-cumulative cap, the tenant would pay the 2 percent increase in the first year, and just a 5 percent increase in the second year of the lease.

“A savvy landlord will want to word the CAM cap to be cumulative rather than non-cumulative,” stresses Oberfeld. A cumulative cap is based on the maximum amount chargeable payable by the tenant, not what the amount actually was,” he explains. “A landlord doesn’t want to lose its traction just because it was able to keep expenses low one year,” Oberfeld warns, noting that the cumulative multiplier effect works in favor of the owner because if it uses the larger number as the payable number, it will grow faster over the subsequent years of the lease.

Practical Pointer: Carefully consider whether a CAM cap will be too burdensome administratively. CAM caps can be complicated to manage in a scenario where multiple tenants each have their own CAM cap percentages that start on different dates. Keeping track of this information, which might be in percentages or in older leases on a dollar per square foot basis, and remembering to back out exclusions like carveouts is a headache and a financial risk.

Be Careful About Carveouts

Usually, there are carveouts to a CAM cap to deal with situations where the owner generally can’t control an expense, but shouldn’t be saddled with it. Common uncontrollable expenses are utilities, insurance, and taxes, and snow removal in some cold climates. Oberfeld suggests that owners should add a catchall for any expenses that are “beyond the reasonable control of the landlord.”

Negotiate ‘Reset’ for First-Year Cap

Most CAM caps start in the second year of a lease, but some large tenants insist on first-year caps and subsequent-year caps. The typical first-year cap takes the form of a dollar amount per square foot. For example, in the first year of a big box retailer’s lease, the amount won’t exceed four dollars per square foot for, let’s say, taxes. When the subsequent year’s cap kicks in in the second year of the lease, that amount won’t increase more than 3 percent per year. While that essentially locks in a favorable number for the tenant, it’s terrible for an owner. Let’s say it costs an owner $5 per square foot for taxes the first year and the tenant has to pay only $4 under its first-year cap. The owner has lost $1 per square foot per year in perpetuity.

“First year CAM caps are a trap that landlords get into; it will hurt them every year for the rest of the lease. If a landlord has to agree to a first cap, it should at least mitigate that concession by asking for a ‘reset’ when the tenant exercises its options,” Oberfeld says. “A reset means that the landlord doesn’t suffer for another five years,” he points out.

Ask your attorney about using the following CAM cap language and catchall language, which kicks in the second year of the lease and gives the possibility of a reset. Carveouts are also built into this provision.

Model Lease Language

Limit on Operating Expenses. Tenant shall not be required to pay any portion of the Pro Rata Share of any Common Facilities Charges that exceed one hundred ________ percent (______%) of the maximum amount of the Common Facilities Charges for the prior calendar year calculated on a cumulative basis (“Cap on Charges”). Notwithstanding anything to the contrary, the foregoing Cap on Charges shall not include Taxes, Landlord’s Insurance, utilities, snow removal, management fees, and any Common Facilities Charges which are not within the control of Landlord (as determined by Landlord), and Tenant shall pay its entire Pro Rata Share of such charges. In the event that the Demised Premises are expanded during the Lease Term, the maximum amount of the Common Facilities Charges used to calculate the Cap on Charges shall be reset in the Lease Year in which the expansion occurs in proportion to the increase in the size of the Floor Area of the Demised Premises. 

Transform Costs to Tenant’s Responsibility

When negotiating operating expenses, Oberfeld says to picture three categories of work: (1) owner maintenance; (2) common area maintenance; and (3) tenant maintenance. “If the landlord can characterize work as tenant maintenance, the landlord doesn’t have to do it or pay for it,” he stresses. “If an owner can characterize work it has to do as CAM instead of owner’s maintenance, then it would be done by the owner but paid for by the tenant,” he adds. “But if the work is done under the landlord’s maintenance provision, then it’s typically done at the landlord’s expense,” he warns.

So, if there are expenses in the owner’s maintenance provision that the owner wants to include in CAM, it should indicate that in the lease; where it would say that the owner “will remove snow” insert “which shall be included in the common area expenses.” It needs to be clear that even though this item is in the owner’s maintenance provision, it’s also intended to be a reimbursable expense under the CAM provision. Like most lease terms, the wording of this provision is key; the phrase “which shall be included in common area expenses” transforms the work from being paid for by the owner to being paid for by tenants.

Insider Source

Neil Oberfeld, Esq.: Greenberg Traurig, LLP, 1200 17th St., Ste. 2400, Denver, CO 80202; http://www.gtlaw.com/.