How to Negotiate Smart Capital Replacements Pass-Through Clause

When you make capital replacements at your building or center, such as replacing the roof or an HVAC system, you'll want to pass through the cost of this work to your tenants as an operating expense/CAM cost. But most tenants will resist agreeing to let you pass through the cost of capital replacements, because that is a huge expense.

If you have some negotiating power, you should try to get the right in your lease to pass through the costs for at least certain types of capital replacements—for example, those that are required by law, make the building safer, or save money. But don't draft the capital replacements pass-through right so narrowly that a savvy tenant can wiggle its way out of paying its full share. Otherwise, you will end up paying the cost of the capital replacement—and that could take a big bite out of your wallet.

To help you draft an effective capital replacements pass-through clause, CLLI will give you six tips. If you follow these tips, you will be able to pass through three types of capital replacement costs and ensure that the tenant will pay its full share of those costs. We will also give you a Model Lease Clause that includes these tips that you can adapt and use in your lease (see p. 3).

Tip #1: State Exception to Capital Replacement Exclusion

When negotiating with the tenant, you will probably have to agree to exclude the cost of capital replacements from the “operating expenses” or “CAM costs” that are passed on to the tenant. But get the tenant to agree to exceptions to this exclusion, say San Francisco attorney Richard C. Mallory and New Jersey attorney Marc L. Ripp. This way, you won't always be responsible for paying capital replacement costs, he says. Our Model Lease Clause refers to these exceptions as “Pass-Through Capital Replacement Expenditures” [Clause, par. a].

***

Practical Pointer: Our Model Lease Clause lets you pass through capital costs for the repair or improvement of your building's or center's structural components. It only bars you from passing through the cost for the replacement of the building's components. That way, the tenant is still on the hook to help pay for capital repairs and capital improvements, says Ripp. But with a few exceptions, expect a tenant with negotiating power to try to make you agree that you won't also pass through the costs of capital repairs and improvements, notes Mallory.

***

Tip #2: List Three Key Types of Pass-Through Capital Replacement Costs

Get the tenant to agree that you have the right to pass through the cost of at least these three types of capital replacements, suggest Mallory and Ripp:

Replacements required by law. Get the right to pass through the cost of any capital replacements made during the lease term that are required under any government law or regulation, say Mallory and Ripp [Clause, par. (b)(i)]. In practical terms, this lets you pass through the costs of replacements to the building or center that are required by new laws and regulations that didn't exist before the lease was signed—for instance, removing fiberglass, says Mallory. A tenant should agree to this.

***

Practical Pointer: Expect a savvy tenant to refuse to let you pass through costs relating to any capital replacements made to remedy a condition for which you get a violation notice, but don't cure by the date the lease is signed, notes Mallory.

***

Cost-saving replacements. Get the right to pass through replacements that save money—for example, replacing the lighting system with an energy-efficient lighting system that can lower electricity bills. To get your tenants to pay for all your cost-saving capital replacements, make sure:

• You pass through replacements “intended” to reduce costs. State in the lease that the pass-through right applies to costs of capital replacements “intended” to reduce operating expenses or CAM costs, or improve the utility, efficiency, or capacity of any of the center's or building's systems, such as the HVAC system, says Ripp [Clause, par. (b)(ii)]. That way, there does not need to be an actual reduction in costs for the replacement to qualify.

• You are not limited to passing through only future replacements. Try not to limit your pass-through right to cost-saving capital replacements started after the lease is signed, says Ripp. You may have started making cost-saving capital replacements before the lease was signed but won't finish them until after the lease starts. If the tenant is benefiting from those replacements, it should pay for them, he says.

• You do not have to set a minimum amount of cost savings for the replacement to qualify. Do not set a minimum amount of money that a capital replacement must save for it to qualify as a cost-saving capital replacement, says Ripp. And do not give in to a tenant's demand that you limit the pass-through to those capital replacements that annually save an amount that is more than the amortized cost of that capital replacement that year, he adds. Otherwise, you will severely limit the pool of potential cost-saving capital replacements.

***

Practical Pointer: A shrewd tenant may demand that you cap the pass-through at the actual amount of the cost savings, he says. The tenant may argue that it need not pay for a capital replacement that turns out to be a bad investment and that does not save any money. Try not to give in to that demand, suggests Ripp.

***

Replacements that improve security. Get the right to pass through the cost of any capital replacements needed to improve security at your building or center, advises Mallory. For example, you will want the right to pass on the costs to replace an older and less sophisticated security system at your building or center with a new security system to protect your tenants and the building or center from criminals and terrorists. And make sure that you, alone, will determine whether or not the security-related capital replacement is needed, he adds [Clause, par. (b)(iii)].

***

Practical Pointer: A tenant may demand that you be reasonable in your determination of whether the security-related capital replacement is needed, says Mallory. You may have to give in on this point if the tenant otherwise refuses to accept this capital replacement category.

***

Tip #3: Get Right to Make Key Cost Determinations

The lease should specify who will decide if a cost 1) is of a “capital nature;” 2) will apply to a replacement of your building's or center's structural components; or 3) is considered a pass-through capital replacement cost, notes property owner and manager Skip Duemeland. Otherwise, you and the tenant will be at odds over who has that right. Ripp suggests that only you have that right [Clause, par. c].

Tip #4: Agree to Amortize Cost, But Get Two Protections

Ideally, when you make a capital replacement, you will want your tenants to immediately pay its full cost. But tenants will always push you to amortize the cost of a capital replacement over the length of the useful life of the replacement, and not let you add in that cost all at once, notes Duemeland. That's obviously not to your advantage, because it lengthens the time before you get paid.

As a compromise, agree to amortize the cost of the capital replacement, but get these two protections in return:

• Tenant pays you interest. The tenant must pay you its share of the amortized cost of the three types of specified capital replacements, plus interest on the unamortized portion of those replacements, says Ripp. After all, the tenant will benefit from the capital replacements right away, despite paying for them over time. Mallory recommends choosing an interest rate equal to the floating commercial loan rate announced from time to time by a specified national bank as its prime rate, plus a set amount—for example, 200 basis points—per year.

• You determine “useful life.” Because the capital replacement's cost will be amortized over the length of the “useful life” of the replacement, the lease must address who or what determines how long the useful life is, notes Duemeland. Mallory and Ripp suggest that you solely make that determination [Clause, par. d].

Tip #5: To Avoid Disputes, Specify When Payments Are Due

Specify in the lease when the tenant's amortized share of the capital replacement costs is due. State that the tenant must pay its share of the costs of a capital replacement amortized each year, beginning in the calendar year in which the capital replacement is started and in each subsequent calendar year of the lease, says Ripp [Clause, par. d]. This way, you can avoid arguments about when those payments are due.

***

Practical Pointer: A persistent tenant may demand that you agree to give it proof of the savings from all cost-saving capital replacements before it will pay its share of the cost. Try not to give in to this demand either, says Ripp. If the tenant has a right to audit your books and records, it can check for proof of money savings if it audits, he adds. The tenant may also refuse to start paying the amortized cost of the capital replacement until the capital replacement has been completed. If the tenant has lots of negotiating power, you may have to give in on this point.

***

Tip #6: Make Tenant Pay for Replacements Necessitated by Its Acts, Omissions

If you determine that you must make any type of capital replacement because of something the tenant did or did not do, require the tenant to pay the entire cost of your replacement work (not merely a proportionate share of it) all at once, as a part of its additional rent, at a time that you choose, says Ripp [Clause, par. e].

Example: A tenant's employee causes a fire that destroys your HVAC system. You replace the HVAC system. You have the right to demand that the tenant pay the entire cost of the HVAC system replacement as part of its next installment of additional rent.

Including the capital replacement's entire cost in the tenant's additional rent is important, notes Ripp. If the tenant does not pay that cost fully, you can sue the tenant for the nonpayment of rent, he says. Nonpayment of rent proceedings are typically quick.

CLLI Sources

Skip Duemeland: CEO, Duemelands Commercial LLP, 301 E. Thayer Ave., Bismarck, ND 58501; (701) 221-2222; skip@duemelands.com.

Richard C. Mallory, Esq.: Partner, Allen Matkins Leck Gamble Mallory & Natsis LLP, 3 Embarcadero Ctr., 12th Fl., San Francisco, CA 94111-4015; (415) 837-1515; rmallory@allenmatkins.com.

Marc L. Ripp, Esq.: Senior Associate Gen. Counsel, Mack-Cali Realty Corp., 343 Thornall St., P.O.B. 7817, Edison, NJ 08818; (732)590-1554; mripp@mack-cali.com.