Once parties to a lease (those being a landlord and its tenant) agree that the tenant will pay a share of operating expenses (or call them common area maintenance – CAM – costs) or taxes, what has been agreed is that the tenant will pay its share, not 35% of its share (or some other figure, like 92% or 107%). Yes, its share!
We’ve Ruminated about some aspects of what falls into the bucket called CAM Costs or Operating Expenses, and we’ve Ruminated about what might and might not be a “tax.” [We have more to say about a “tax,” but not this week.] But, once you’ve determined what falls into the bucket and what the tenant’s percentage might be, is there anything to do beyond some multiplication? Very often, the answer is “yes.” Tenants like to “cap” what they pay, i.e., pay no more than some negotiated limit even after Operating Expenses or taxes have been allocated by a fair percentage formula.
What’s the reasoning or logic behind that? If a “cap” is requested to arbitrarily permit the tenant to pay less than its agreed-upon fair share, the logic is clear – “I don’t want to pay my full fair share.” But, that’s not a legitimate reason. If that’s the reason, let a tenant say, in the first place: “we will pay 80% of what we should pay if we were paying our full share.”
Ruminations has figured out two valid reasons. By valid, we mean reasons based on a tenant’s legitimate concerns. The first has to do with imposing “discipline” on the landlord – “spend what you want, but we aren’t paying more than you should have spent, modeled on what you spent in prior years.” The second has to do with managing the tenant’s expenses – “we are budgeting or modeling this location for an expected occupancy cost and don’t want to see sharp increases on a year to year basis beyond our budget.” As we’ve posited above, the invalid reason is to employ a “cap” as a back door way of paying less than a fair share. Make no mistake, there is nothing wrong with paying less than a fair share, but that should be worked out up front, when the rent numbers are being discussed.
Fair warning, this posting is pretty long and has “numbers” in it.
The concept of a “cap” has four attributes. The first is “what expenses will be covered by the ‘cap’”? The second is that it limits how much the tenant will actually have to pay in any given period, almost always an annual period. Another is the way the “cap” is calculated. The last is whether any unrecovered costs resulting from application of the “cap” in a prior year will ever be recovered.
The second and the last attributes are related and are the simplest to explain, most easily by example. Suppose there is a $10,000 cap on what the tenant has to pay in any given year. Now suppose the tenant’s “full share” over the years would be as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.
The tenant with $10,000 annual payment “cap” would be obligated to pay the following: On account of Year 1 = $9,000; Year 2 = $10,000 (the “cap”); Year 3 = $9,700 ($9,000 plus the unrecovered $500 from Year 2); Year 4 = $10,000 (the “cap”); Year 5 = $10,000 (the “cap”); and Year 6 = $9,700 ($8,500 plus the unrecovered $1,000 from Year 4 plus the unrecovered $200 from Year 5). You could play with “interest” on the unrecovered, carry-overs from prior years.
That arrangement, recovering the excesses in future years, is called a “cumulative cap.” Under a “cumulative cap,” the landlord recovers all of its expenses (eventually, with some wiggle room for the last years of the lease term), and the tenant gets budgeting stability.
In contrast, if the “cap” were agreed to be “non-cumulative,” using our example, the landlord would not recover $1,700 (the aggregate of the “excess” amounts for Years 2, 4, and 5.
The second attribute, what does the “cap” cover, is often thought of in terms of “controllable” versus “uncontrollable” costs, with many dealmakers agreeing that the “cap” should only cover “controllable” costs. Ruminations doesn’t think that makes any sense if the reason for a “cap” is to keep a tenant’s occupancy costs within a “budget.” We also have some arcane notions to the effect that the distinction between “controllable” and “uncontrollable” costs doesn’t much comport with the concept that a “cap” will encourage landlords to be more prudent than they would otherwise be in spending money – a way to stop a “drunken sailor.” [In the interest of balanced writing, we feel obligated to present an opposing viewpoint from Bruce L. Hargraves, as reported by Fox News Radio station WKLT: “To the Editor: I object and take exception to everyone saying [names] are spending like a drunken sailor. As a former drunken sailor, I quit when I ran out of money.” On reflection, Mr. Hargraves seems to be endorsing a “non-cumulative cap” as a means to impose spending discipline on landlords.]
We understand why, as is common in the northeast, the parties agree to take “snow removal costs” out from under a “cap.” We might understand taking “insurance premiums” out from under the “cap,” but don’t think it makes much of a difference, except, perversely to reduce the permissible recovery amount. We say that because, to the extent insurance premiums are fairly stable, as history would indicate but for a few oddball years, taking “insurance premiums” out from under the cap actually gives the landlord less “margin” for variability of its other costs. The same could be said for utility costs, another common “carve-out.” With that in mind, perhaps the distinction should be “readily forecastable costs” as contrasted with “not readily forecastable costs.” [For a treatise on the difference between a “forecast” and a “prediction,” you may want to look at Nate Silver’s recent book, The Signal and the Noise.]
Whatever the parties agree-upon in the way of what costs will be “capped” and what costs will “ride free,” the draftsperson will want to define the two categories, “capped costs” and “uncapped costs,” and then say the tenant will pay the sum of: (a) its share of the “uncapped costs”; plus (b) the lesser of its share of the “capped costs” or the “cap” itself.
Now it gets even a little more complicated – how is the “cap” to be calculated? Basically, this question drills down to: “Is this year’s ‘cap’ based on what the tenant actually paid last year” or “is this year’s ‘cap’ based on what the ‘cap’ was last year”?
Here are more examples. For each of the next examples, we’ll use the same “actual” costs as we have already been using
Suppose the tenant’s “full share” over the years, which is its full pro rata share of the actual cost, is as follows: Year 1 = $9,000; Year 2 = $10,500; Year 3 = $9,200; Year 4 = $11,000; Year 5 = $10,200; and Year 6= $8,500.
Now, for our first example, we will base the “cap” on what the tenant had paid in the previous year. We’ll use a 5% annual “cap” in our example, but that’s not even a hint of a suggestion that 5% is appropriate from either party’s perspective.
In Year 1, the “cap,” unless separately stated in the lease (something we urge be done – more about that later), does not apply. So, for Year 1, the tenant pays $9,000. That makes the Year 2 “cap” $9,450 (5% more than the $9,000). Since the actual cost for Year 2 was “10,500, and its “cap” is $9,450, the tenant pays only $9,450, leaving the landlord “short” by $550. For Year 3, the cap is 5% more than the $9,450 paid by the tenant for Year 3 ($9,922.50). Since the actual cost for Year 3 was only $9,200, the tenant only pays $9,200. Based on the Year 3 payment of $9,200, the cap for Year 4 is $9,660 (that’s 5% higher). With actual costs of $11,000, the tenant pays only the “cap” of $9,660, and the landlord takes a hit of $1,340. Year 5’s “cap” is 5% above Year 4’s payment, and that comes to $10,143, again a loss to the landlord, this time only $57. For Year 6, the cap is $10,650, but the tenant only pays the lower figure, the actual costs, of $8,500.
In that example, it is obvious that if a “cumulative cap” is not the deal, the landlord takes a hit of $1,947. If a “cumulative cap” is the deal, the landlord would have gotten its full cost recovery, though spaced out over time and the tenant would have gotten budget stability.
What’s not obvious is that, because the Year 6 payment was only $8,500, the landlord might never catch up. The average six year annual cost is (trust us), $9,773.33. If the landlord’s cost went up by 3% annual inflation and for no other reason, with a Year 7 “cap” of $8,925 and using the “average cost” of $9,773.33 as the true annual cost for Year 6 without inflation adjustment, it wouldn’t be until Year 14 (again, trust us) when the actual cost will be less than the “cap.”
What that means is that if a landlord, whether by accident or design, really, really gets an unusually low “cost” year, (perhaps there were no parking lot repairs that year because, as an unrecoverable capital cost in the prior year, it re-did the entire parking lot), it would get “killed” if the “cap” is based on the prior year’s actual payment from the tenant.
Here’s another example related to the parking lot. Assume it costs $1.00 a line to restripe the parking lot if you do 500 stripes at a time, but only $0.60 per stripe to do an entire 3,000 stripe lot. Do you do 500 stripes a year and get that “constant” cost into the CAM costs, or do you do all $3,000 every six years, but face the prospect of having the CAM costs in the striping year jump well ahead of the “cap”? Make up your own examples.
So, is the other alternative any better? Would calculating each year’s “cap” based on the prior year’s “cap” be any better? Even before showing any examples, one thing is certain – if you follow this method, the tenant’s budgetary needs will be met. In fact, once you determine the base cost “pass-through” amount, you can calculate the “cap” for the remainder of the lease term. It only depends on the first year. Here’s an example using the same “full share” cost for Year 1 as we have used above. [Again, we think the parties should agree on the “cap” for Year 1 and not just let it turn out to be whatever it might turn out to be. They can do this using the historic costs for prior years.]
We’ve said that the actual cost for Year 1 was $9,000. Using a 5% factor, we then get the following “caps”: Year 2 = $9,450; Year 3 = $9,923; Year 4 = $10,419; Year 5 = 10,940; and Year 6 = $11,487.
Using the actual costs for Years 2 through 6 in our examples, these “caps” will have little effect. Without a “cumulative cap,” the landlord will “lose” $1,631 and probably not a drop more after that. That’s because the “cap” is running away from the costs. This means that while the goal of giving the tenant a budgeting tool has been met, there is no incentive, by reason of the “cap,” for the landlord to control its costs.
So, is there a solution? Some landlord representatives would say, “yes – no ‘cap’.” But, if you want to make a deal, that position is likely to be found on the cutting room floor. Ruminations thinks both landlord and tenant need to be honest with each other about their respective objectives. Landlords should respect their tenants’ need to stay within budgeting limits. Tenants, once having decided to “go” with a particular landlord based, in part, on what the shopping center or other type of property looks like (Class A, B, C, etc.), shouldn’t try to control costs by limiting spending. If the work needs to be done, it needs to be done. Tenants shouldn’t let short-term goals create long term problems (think about the parking lot striping).
So, we think cost control should be addressed directly in the lease if the tenant is truly concerned – establish standards, call for CAM or Operating Expense budget review ahead of time, etc. We also think that a tenant is entitled to predicable cost limits for any given year, but that landlords should be able to recover the “excess costs” if, on average, the costs aren’t running away. The focus should be on distinguishing between “readily forecastable” costs and “not readily non-forecastable” costs, not on some misguided concept of “controllability.”
The math is too complicated to set forth here, especially because we are already beyond our text-limit goals for weekly postings, but Ruminations thinks the “cap” should be based on a rolling average, perhaps the prior three- year average, of actual costs.
One last thought (for now). If you’ve read this far, why would someone think that it is “proper” to place a “cap” on real estate taxes and make it “non-cumulative”? Aren’t they “what they are”? Isn’t there an obligation in the lease already or an “external” reason to challenge excess taxes? And, in most cases in a rising economy (which may really be happening again), don’t tax increases come from rate changes and not from overstated valuations (assuming they weren’t overstated in the first place)?
What’s the bottom line? Our answer – it depends. It depends on what a tenant’s true motive might be when it negotiates for a “cap.” For a further explanation, we invite you to revisit the fourth paragraph of this posting.