How to Negotiate for Including Capital Improvement Costs in Tenant’s CAM Charges

Consider four strategies for compromise.

Capital improvements are essential to the long-term success and competitive advantage of any commercial rental property. They’re also very expensive. Consequently, landlords may seek the right to include capital improvement costs in the common area maintenance (CAM) charges or operating expenses (which we’ll refer to collectively as “CAM”) that the lease requires tenants to pay to contribute to maintaining the property’s common areas. This is often a hotly negotiated issue with high financial stakes for both sides.

Accordingly, landlords often have to make compromises, particularly when facing strong tenants with significant bargaining leverage. The good news is that it need not be an all-or-nothing proposition. There are a number of compromise approaches that you may be able use to persuade a tenant to let you include capital improvement costs in CAM. Here’s a look at four compromise strategies that attorneys say are particularly effective and how you can execute them when negotiating CAM costs with your own tenants.

What’s at Stake

New roofs, electrical system upgrades, additions, remodeling, and other capital improvements come with a high price tag. But refraining from making them to save money can undermine not only your property’s aesthetics and consumer appeal but also its structural integrity and safety. It also puts you in the rob-Peter-to-pay-Paul position of having to make rent and other financial concessions to attract and retain tenants. The result is often a lethal spiral in which reductions in rental income make essential capital improvements even less affordable.

Being able to pass along the costs of capital improvements is the key to avoiding this dilemma, at least for many landlords. In a landlord utopia, tenants would pay the entire costs of capital improvements via increases to their CAM charges in the year the landlord incurs them. But in the real world, getting tenants to pay for improvements is a tall order. Many tenants believe that CAM should be reserved for maintenance and that landlords should pay for long-term projects designed to improve the property. And while tenants also benefit from improvements, the life of those benefits often exceeds the terms of their own particular lease.

Moreover, even tenants who are willing to accept financial responsibility for capital improvements are generally reluctant to grant the landlord carte blanche lest their CAM costs spiral out of control. They also worry that the landlord will abuse their pass-through rights to make extravagant and unneeded improvements at their expense.

4 CAM COMPROMISES TO PERSUADE RELUCTANT TENANTS

You can allay these fears by structuring a CAM pass-through arrangement that ensures that tenants pay only for their fair share of capital improvement costs. Here are four different approaches that can be used either on their own or in combination with each other.

1. Include Only Amortized Costs

The reluctance of tenants to pay for improvements that are of greater long-term benefit to the landlord and its future tenants than to their own business is both understandable and reasonable. One way to address this concern is to agree to include only the annual amortized portion of capital improvement costs when calculating the tenant’s annual CAM costs or operating charges [Clause, par a].

Example: If the life of a high-efficiency windows replacement improvement is 10 years, you could agree to include only one-tenth of its costs in CAM charges each year for 10 years. Thus, a tenant with four years remaining on its lease would contribute only four-tenths of the improvement’s costs. And since the tenant will benefit from the windows during its final four years in the premises, it will end up paying only for what it gets from the improvement.

Using this approach on a consistent basis enables you to fully recover your costs since you’ll be able to charge the new tenant(s) that take(s) over the premises its/their pro rata share of the remaining costs, e.g., one-tenth per year for six years in the example above.

2. Use IRS Code to Determine Useful Life of Improvement

There may be disagreements over what constitutes the useful life for a particular capital improvement, with tenants likely to cite the longest and landlords the shortest possible life. The abundance of amortization tables available on the internet will make it possible for each side to find a table to support its position. So, you might want to settle on a single authoritative source, such as the longest useful life permitted under the Internal Revenue Code [Clause, par. b].

Attorneys say that tenants will probably like this approach because the code, which allows deductions based on amortized capital costs, often provides the longest reasonable useful life of an improvement. Landlords also benefit by avoiding potentially disruptive lengthy disputes with tenants on how to determine an improvement’s useful life. But landlords might also want to balance the scales by establishing a cap on how long the useful life of any improvement can be, regardless of what the code says. For example, our Model Lease Clause provides for using the code’s useful life subject to a cap of 15 years.

The 15-year cap should be acceptable to most tenants, according to attorneys. And having a cap allows you to quickly recover enough of your capital costs to make the improvement affordable. Thus, for example, without a cap, the useful life of an improvement could be 30, 40, or even 50 years, meaning you’d be able to collect only one-thirtieth/one-fortieth/one-fiftieth of the improvement’s costs over a 30-/40-/50-year period. 

3. Cap Annual Costs

If the first two concessions aren’t enough to assuage a tenant’s fears of CAM charges getting out of hand, you can go a step further by setting a hard cap on annual capital costs that can be added to CAM regardless of the actual amount of capital costs calculated on an amortized basis during the year. Attorneys advise expressing the cap as a set percentage of the tenant’s annual rent. Thus, our Model Lease Clause provides that annual capital costs added to CAM may not exceed 10 percent of fixed rent [Clause, par. c].

Example: If the annual cap is 10 percent, a tenant that pays $100,000 in fixed annual rent will know that the amount added to CAM charges to cover capital improvements won’t exceed $10,000 per year.

The actual cap amount will be subject to negotiation based on several factors, including the building’s current condition. Thus, a landlord may be willing to accept a lower cap if the building is in mint condition but seek a higher cap if it’s in need of major improvements. The problem, of course, is that the landlord’s bargaining leverage is likely to be inversely proportional to the building’s condition. Another key factor is the length of the lease term. The longer the lease, the greater the need for a higher cap due to the greater likelihood of needing to make capital improvements at some point during the lease term.   

4. Include Capital Costs Only After Improvement Is Completed

Capital improvement projects often take years to complete. During that period, landlords must make payments to their various contractors, subcontractors, and suppliers. As a result, landlords typically seek the right to add capital improvement costs to CAM charges in the year they’re incurred. However, attorneys caution that tenants may push back by demanding that capital improvement costs be added to CAM only after the improvement is actually completed.

Why should I be on the hook for an improvement from which I’m not currently benefiting, the tenant may reason. And what if the improvement is completed only after my lease ends and I end up realizing no benefit at all? In that case, the landlord should expect not me but the future tenant to pay the improvement’s costs.

Our Model Lease Clause provides for a compromise by stating that capital costs won’t be added to the tenant’s CAM charges until the improvement is completed [Clause, par. d]. However, think twice before agreeing to such a limitation. The first thing to consider is your cash flow and whether you’ll have enough cash on hand to make the necessary payments for the improvement without immediate and regular contributions from tenants. Charging some tenants for capital costs as they’re incurred while requiring others to pay after project completion can also create significant administrative and accounting headaches.

The rule of thumb, then, is to not give in to the demand for deferral unless it’s absolutely necessary to conclude a lease deal with a highly desirable tenant. In the words of one seasoned Chicago attorney: “At the end of the day, recovering capital costs after completion of the improvement project is still better than not getting them back at all.”